By Bruno Giordano, MBA, CFP
What if stocks, in the near future, trade at their historic average valuations?
What if what happened to the “nifty-fifty” (largest capitalization stocks) in 1973-1974 happens to the largest capitalization stocks in the index funds?
What if what happened when the DOW hit 100 and 1000 happens when the DOW hits 10,000?
Only if you are a market historian can you even begin to imagine how terrible those thoughts are. Let’s hope that none of them come true. Better to hope than be prepared for the worst and expect the best. Right?
Let’s look back in history and understand what has happened before.
I am a certified financial planner and my company is a registered investment advisory firm. I read everything financial I possibly can, go to meetings of my peers, listen to tapes, watch the gurus on TV. In short, I know what the majority of financial planners and investment advisors are telling their clients, namely, that stocks will produce future gains at their long term historical average, somewhere between 10 and 13 percent per year.
Unfortunately, if stock valuations regress to the mean, (doesn’t everything?), that means they will have to under-perform the average after years of performing above the average, but by how much?
Two economics professors, Robert Shiller of Yale University and John Campbell of Harvard University, have done some forecasting for us. They tell us, if it takes 10 years to return to the norm, a price-to-earnings ratio of about 14, the S&P 500, adjusted for inflation, will end up about a third lower (33 percent loss) than it is today. If it takes less time to return to the norm, it will be worse.
As an aside, the stocks that comprise the NASDAQ 100 have P/E’s of more than 100 on average, twice what the nifty-fifty had in the early 1970’s. America On Line goes for over 400 times earnings and Yahoo for over 800 times earnings. Eee-Haah!
But what if the P/E ratio overshoots, like it usually does, and goes to six, like it did in December 1974? The resulting decimation of the S&P 500 is just too terrible to put into words.
Next let’s look at the “nifty-fifty”, or “let’s all invest in the index” syndrome.
According to Robert Adler, of AMG Data Services, this year through March 17, 1999, an astonishing 68.4 percent of the new net cash flow into equity funds has gone into large capitalization index funds. During the same period last year only 16.4 percent of the total new net cash flow went into large-cap index funds.
How about that? I wonder which local mutual fund company we largely have to thank for that?
In my opinion, a lot of motivation for all this money mindlessly pouring into the S&P 500 index is based on reports that the S&P 500 index has outperformed most of the active money managers.
What a lot of people don’t understand is that the S&P 500 is capitalization weighted: that is the larger the company, the larger the effect it has on the index. The S&P 500 is not simply a gathering of 500 stocks.
Take companies like GE and Great Lakes Chemical, both leaders in their industry. Because GE is so much larger, its effect on the S&P 500 is approximately 81 times greater than that of Great Lakes Chemical.
Does anyone structure their portfolio like that? If Fidelity Magellan is 81 times larger than some small mutual fund, do you buy 81 times as much Magellan?
In short, the index is egregiously representative of about the fifty largest companies, not the 500.
History never repeats itself exactly, but the similarities between now and the early 1970’s give me pause.
In 1973-1974, the large-cap stocks dropped 90 percent (that’s not a typo) over an 18 month period even though there was hardly any change in the underlying fundamentals. Could it happen again? A terrible thought indeed! Also not a stylish one.
“Not to worry,” say some S&P 500 index believers, if you had bought the nifty-fifty in 1972 and suffered through the terrible loss, you would have recouped your losses in only 15 years or so, and if you had held through to today, your overall rate of return wouldn’t have been too bad.
It only took 25 years or so to demonstrate that buying the nifty-fifty in 1972 wasn’t such a bad idea after all. At least not until the next prolonged, secular bear market.
Of course, these pundits are basing their recommendations to their clients for the next 15 years on what happened in the last 15 to 20 years.
Imagine if you had done that in 1944. No stocks, thank you, and you miss the 1944 to 1966 Bull Market.
What if you had done that in 1966? Lots of stocks now. Sorry, from 1966 to 1982, virtually no growth and a couple of really horrendous bear markets.
Fast forward to 1982. The last 16 years were terrible for stocks, so let’s avoid them. After all, “Equities are dear,” the pundits told us. If you had done that you would have missed the 1982 to present Bull Market.
As the Securities and Exchange Commission and the National Association of Securities Dealers routinely admonishes registered investment advisors: “Past performance is not necessarily an indication of future performance.”
Next, what about the possible curse of the logarithmic numbers: 100, 1000, 10,000?
The following statistics come from a thought provoking article by Peter Eliades (always one of my favorite financial writers) in the March 22, 1999 Barrons article, “Nasty Numbers”.
The DOW first breached 100 on January 12, 1906. It took nearly 19 years to get significantly past it. Nineteen years!
In between, the DOW declined 48.5 percent to a November, 1907 low, came back in 1909 and hovered there until 1912 when it slid down 30 percent by 1914. In November, 1916 it was 110 then it declined 40 percent in 13 months. In November, 1919, it was 119.62. By 1921 it was off 46.6 percent. Finally, a bull market began in 1924 that carried it to 381.17 on September 3, 1929. We all know what happened at that point. Ouch!
In January, 1966 the DOW broke 1000 intra-day. Then it declined 26 percent. By December, 1968 it hit 994.65. From that point to October, 1974, the average share price declined 75 percent. Ouch again! The DOW continued to flirt with level 1000 back and forth until August, 1982. That’s merely 16 years of going nowhere.
By the way, 1982 is when the headlines screamed, “Equities Are Dead” just before the greatest Bull Market in history! Is conventional wisdom always wrong?
On February 24, 1983, the DOW closed at 1121.81 and the greatest Bull Market in history was off and running. It had only taken 17 years to get through the 1000 barrier curse.
Will 10,000 prove to be a curse number? Did I forget to mention the possible effect of the Y2K problem? How do we cope with the possible consequence of terrible thoughts and nasty numbers?
One way is to utter those words that my hero, Sir John Templeton, said would be the most expensive words you will ever utter: “It’s Different This Time.”
Bruno A. Giordano, MBA, CFP is president of Dorset Financial Services in Devon, Pa.