Saturday, July 11, 2009

New Holes in Various Investment Theories

In Does Stock-Market Data Really Go Back 200 Years, Jason Zweig of the WSJ casts doubt on Dr. Jeremy Siegel's data and by implication Wall Street sales data designed to intimidate people into risking their funds in the public stock market because of alleged great performance over 2 centuries. Here are some quotes from the article:

Prof. Siegel based his early numbers on data first gathered decades ago by two economists, Walter Buckingham Smith and Arthur Harrison Cole.

For the years 1802 through 1820, Profs. Smith and Cole collected prices on three dozen banking, insurance, transportation and other stocks -- but ended up including only seven, all banks, in their stock-market index. Through 1845, they tracked 19 insurance stocks, but rejected 95% of them, adding only one to their index. For 1834 onward, they added a maximum of 27 railroad stocks. . .

The database of early U.S. securities at has so far identified more than 1,000 stocks that were listed on 10 different exchanges -- including Charleston, S.C., New Orleans, and Norfolk, Va. -- between 1790 and 1860. Thus the indexes relied on by Prof. Siegel exclude 97% of all the stocks that existed in the earliest years of the U.S. market, and include only the bluest of the blue-chip survivors. Never mind all of the canals, wooden turnpikes, rubber-hat companies and the other doomed stocks that investors lost millions on -- and whose returns may never be reconstructed.

This data fits with common experience from the late 1990s. Most tech stock investors got burned; the insiders and the financial community made money. The average mutual fund investor saw almost none of the benefits of the long-term bull market, generally chasing performance and thus buying high and selling low. The soundest bull market of the 20th Century in the U. S. was brief, and occurred after the U. S. had dominated the world after WW II, and the Dow yielded something like 7% while Treasury bonds yielded 2%. There have been huge stretches where Treasuries out-performed stocks, ignoring the peace of mind inherent in a buy-and-hold strategy with Treasuries. Let us not neglect the intermediate strategy of investing in corporate bonds, with higher yields than Treasuries and low default rates whenever the economy was strong enough to support a strong stock market.

Basically, Wall Street wants to sell stocks, either through IPOs or by recycling "used" stocks at any price---just so there's a transaction with fees for the Street. Be cautious selling what you own just because you have a profit---or a loss!

The WSJ also laments the failure of the diversification theory of investing in Failure of a Fail-Safe Strategy Sends Investors Scrambling:

Carl Mahler stood before a group of fellow financial advisers recently and voiced frustration and fear that a fundamental tenet of investing had been proved wrong.

"Hi. My name is Carl, and I'm a recovering asset-allocationist," the Raymond James Financial adviser quipped.

Asset allocation, a bedrock of investing for decades, appeared to fail miserably in 2008. The conviction shared by most investors -- that they should spread their money across myriad asset classes to minimize losses -- was shaken as nearly all markets tumbled in unison.

DoctoRx here. Interestingly, I have generally believed in non-diversification; if the best you can do is match the average performance of all markets, mediocrity is guaranteed. For the first time in my investment career, almost all markets appear balanced re risk-reward. Stocks are far from bargain valuations , but many strong companies sell at 10-12X earnings at a time when no money is available to simply form a start-up and challenge the market leader. Treasuries could turn out to be the next bubble (think Japan) and could have tremendous price upside; but a reversion to historical normal yields would mean large capital losses and thus have similarities to NASDAQ stocks of the second half 0f the 1990s (which year, undetermined!). Gold is finally well-recognized both as an inflation and as a deflation hedge. Hmm . . . which is it? Can gold really be many things to many people? And there's always the threat of confiscation before any new world financial order which revalues gold upwards. Oil is both historically high and low. Etc.

It may be that for the first time in a long time, there are so many cross-currents and so many arbitrary political-economic choices to be made that a diversified portfolio has finally begun to make sense. The more you need to hold onto your capital, the more safe short-duration Ginnie Maes continue to make sense, or plain-vanilla FDIC-insured certificates of deposit.

EBR continues to believe that short-term, inflation is no threat. When Sweden can get away with negative rates to savers, demand for safe non-callable yield could soar (think Treasury bubble). Long-term, inflation will come back. Yours truly is not panicking over it, though. My sources suggest that the great majority of investors are so afraid of it that the contrarian advises to stay away from the crowd on that thesis for now. One wants to own high-quality assets that are out of favor but are likely to be highly sought after in the future, and ideally the assets one own one should desire to own them for years to come should no buyer appear to provide a hoped-for significant profit.

Copyright (C) Long Lake LLC 2009

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