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  Does extinction loom for buy-and-holders?

BENJ GALLANDER and BEN STADELMANN

Friday, December 10, 2004

Gary Larson provided fans with a wealth of exotic wit in his comic "The Far Side," but a particular favourite comes to mind. A sober-looking stegosaurus is at a podium, addressing an assembly of dinosaurs: "The picture's pretty bleak, gentlemen ... the world's climates are changing, the mammals are taking over, and we all have a brain about the size of a walnut."

The bears are growling ever more loudly about an impending financial crisis in the United States. Investment adviser and fund manager Marc Faber says the U.S. dollar will eventually become so devalued that a cup of coffee will cost $100 (U.S.). That's probably not a tip to buy shares in Starbucks.

But the bears represent a vocal minority. The herd on Wall Street acknowledges a problem or two, or the odd "rough patch" in the path of the economic recovery, but their faith in the dynamism and adaptability of the U.S. economy is unshaken, and they proffer a rosy outlook for corporate profits.

The investor who is troubled by this dichotomy might well enjoy John Mauldin's fascinating book, Bull's Eye Investing. From the subtitle, Targeting Real Returns in a Smoke and Mirrors Market, we know right off that this isn't going to be another Wall Street apologia.

Mauldin systematically strips away the bromides that advisers use to convince clients that every day is a good day to purchase stock. Proponents of buy-and-hold investing — such as Jeremy Siegel of Stocks for the Long Run fame and indexing guru Roger Ibbotson — come under withering criticism.

Mauldin emphasizes that the stock market should be looked at as a series of secular bull and bear periods, usually taking around 15 years. By his definition, the last secular bear lasted 16 years — from 1966 to 1982 — with a real return (adjusted for inflation) of 0.3 percent. The following bull market lasted 18 years, from 1982 to 2000, and generated returns of 14.8 percent.

The interesting thing is that, although each period had its share of booms and recessions, there was little difference in overall economic growth and corporate earnings during either.

Instead, the critical factor is investor sentiment, expressed via price/earnings ratios. During the long period in which the market did little, the p/e ratio trended downwards as investors became less willing to pay as much for each dollar of earnings — bottoming out in 1982 with a p/e around 8.

After that, inflation and interest rates waned and stocks jumped, with the average p/e topping at over 30 in 1999. Now we are on the other side of the cycle, and Mauldin reckons p/e ratios will bottom somewhere between 5 and 16 within the next 20 years.

Despite this rather pessimistic outlook, Mauldin painstakingly separates himself from the Chicken Littles who preach economic havoc and destruction. Yes, currency devaluation and personal debt levels will force consumers to make painful readjustments, and older workers will likely have to work longer than anticipated in order to retire, but that doesn't mean depression and bread lines.

In Mauldin's view, America will experience several more years of a "muddle-through" economy, characterized by weak, albeit not awful, economic growth, reasonable price stability, slowly rising interest rates, and a continued loss of jobs to other countries. However, there will be a healthy manufacturing sector spurred by gains in productivity, innovation and low taxes.

Mauldin acknowledges that, even in this bear market, experienced stock pickers can do quite well and that smaller, independent investors might sidestep major damage. Large pension funds and other institutional investors with high expectations for passive investing, however, are like dinosaurs facing climatic change. Like fuzzy little mammals, we'll try to stay warm during the big chill.


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