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% growth, 1987-2004





America (GDP) * Profits (U.S. firms) * Stocks (Dow)
* through mid 2004

FIGURE 8.7 Stock Prices Have Risen Even More Than Profits
Sources: Bureau of Economic Analysis, U.S. Dept. of Commerce, Congressional
Budget Office

When will corporate profits and stock prices slow down to their nat-
ural speed limit? I was pondering this one night while watching a Tonight
Show visit by Phil McGraw (“Dr. Phil”) who was promoting his book
The Ultimate Weight Solution. Jay Leno was making fun of the author™s
weight, and Dr. Phil responded by saying, “Are you saying I™m too fat to
write a diet book?”
Leno responded by saying that he wouldn™t be making the joke except
that the title of the book is the “ultimate” weight loss solution. Less
extreme adjectives, Leno suggested, would have been more appropriate for
a man of Dr. Phil™s size. Presumably, “a pretty good weight loss solution”
or “moderate weight loss for fatties” would not have drawn Leno™s wit.
Professor Siegel does not make a similar mistake in his work promot-
ing stocks. His book is called the Stocks for the Long Run, not “Stocks for
the Super, Super Long Run” or “Jurassic Investing Secrets.” Over the
truly long run, Professor Siegel™s argument cannot be right. Stocks can-
not be the ultimate investment because over the long run, they can only
be average.
Stocks 183

No one knows when the natural speed limit will hit corporate profits
and stock prices. John Maynard Keynes famously quipped, “In the long
run we are all dead.” His point is that arguments about the truly long run
have little meaning to people whose horizons stretch out just a few years.
Just as Microsoft grew very rapidly for more than a decade, there is no
reason to expect an imminent slowdown in the growth of stock prices.
Nevertheless, such a slowdown is inevitable.

Buying Stocks with the Wall Street Bulls

Our fundamental analysis so far has made two conclusions. With current
profit projections and interest rates, stock prices look to be close to fairly
valued. There is some hint of trouble in the fact that both profits and the
valuation of the profits are increasing at unsustainable rates. The next
piece of the valuation puzzle is an attempt to gauge investors™ moods. The
universal investing rule is that popular investments are unprofitable and
vice versa. Where do we stand in the cycle of excessive optimism and
pessimism toward stock ownership?
We can look at Wall Street gurus for clues. The big financial firms
employ market strategists who make both predictions and investment
recommendations. Richard Bernstein is one such strategist who works
for Merrill Lynch & Co. In 2003, Mr. Bernstein was criticized for being
too negative on stocks.16 Bernstein fretted about a number of problems
including the U.S. trade deficit and the possibility of rising interest rates.
Compared to his brethren Mr. Bernstein has been quite negative on
U.S. stocks for years. In 2003, however, stocks prices soared. Investors
who listened to Mr. Bernstein made less money than if they had listened
to his competitors. Not surprisingly, Mr. Bernstein was under fire for his
ursine outlook.
How bearish was Mr. Bernstein? The amazing fact is that for all his
“bearishness” Mr. Bernstein suggested that people invest almost half
their total financial wealth in the risky stock market. How can this be
184 Applying Science and Art to Bonds, Stocks, and Real Estate

considered too bearish? The answer is that we live in an investing climate
dominated by Professor Siegel™s view that stocks are the best investment,
so almost any portion not in stocks is viewed as “bearish.”
Putting almost half your money at risk seems to be quite a bold
suggestion. Nevertheless, Mr. Bernstein was conservative compared to
his peers. Table 8.3 shows the recommendations of a set of leading Wall
Street firms highlighted by the Dow Jones Newswires at the time that Mr.
Bernstein was under fire for being bearish.
This is not a list of the Wall Street bulls; this was the entire list selected
by the Dow Jones Newswires! It shows that Mr. Bernstein was more pes-
simistic about stocks than all of his peers on this list.
This suggests that there is more pain ahead for stocks. While Mr.
Bernstein has been getting less flack of late, Wall Street is still extremely
bullish on stocks. Investments are profitable when they are hated. Recall

TABLE 8.3 In an Optimistic Environment, Caution Is Labeled Pessimistic
Firm Strategist % into Stocks
A.G. Edwards Mark Keller 70%
Banc of America Tom McManus 70%
Bear Stearns & Co. Francois Trahan 60%
CIBC World Markets Subodh Kumar 70%
Goldman Sachs & Co. Abby Joseph Cohen 75%
Legg Mason Richard Cripps 60%
Lehman Brothers Chip Dickson 70%
Merrill Lynch & Co. Richard Bernstein 45%
(the “bear”)
Morgan Stanley Steve Galbraith 65%
Raymond James Jeffrey Saut 65%
Salomon Smith Barney Bill Helman 55%
Wachovia Ken Liu 78%
Source: Dow Jones Newswires17
Stocks 185

that 1982 was the best time to buy U.S. stocks in a lifetime. At that point,
stocks were universally hated and essentially ignored.

Reasons to Own Stocks Even If They Are Only
Average Investments

When I was a teenager, I spent some time at the local roller skating rink.
In addition to enjoying the huge bell-bottoms and other clothes from the
1970s (the decade that taste forgot), I was puzzled by one of the estab-
lishment™s rules. As an unskilled but thrill-seeking skater, I was con-
stantly getting in trouble with the staff for skating too fast.
While I am sure that I did skate too fast, the rules made no sense. “No
skating faster than average” was the law posted around the skating club.
I spent many hours grappling with the logic. If even one person skates
slower than the average, then by pure mathematics, someone else (and
maybe many people) must be skating faster than the average. So the rule
made no sense. The skating rink™s employees were unimpressed with my
logic, but I learned the mathematics of averages.
When it comes to investments, the logic of averages is unavoidable.
No investment class can be above average indefinitely. Stocks have had a
long run and are not cheap. So I don™t recommend buying stocks in the
hopes that they will have higher returns than other assets.
Even if stocks are only average, however, there are some good reasons
to buy them. First, stocks provide protection against inflation and defla-
tion. By buying stocks, and therefore the real assets that they represent,
you are locking in purchases at today™s prices. This means that if inflation
rates rise, the value of those underlying assets should also rise. Similarly,
if prices fall, the assets controlled by the corporation will also fall. So
stocks provide protection in the event that the United States™ long run of
almost perfect inflation rates ends.
Second, stocks provide protection against currency swings. Because
many U.S. companies derive substantial revenue from international
sales, stock prices are buffered against changes in the value of the dollar.
186 Applying Science and Art to Bonds, Stocks, and Real Estate

In 2003, for example, the U.S. dollar lost about 20% of its value against
the euro, and lost substantial ground against most other currencies.18
The decline of the dollar made most Americans poorer. When we go to
buy a bottle of French wine or a car made in Japan, our dollars buy less.
However, the earnings of many U.S. companies were helped by the decline
in the dollar. Continuing our Microsoft theme, a piece of software that sold
for 100 euros brought in over 120 dollars at the end of 2003 versus about
100 dollars at the start of the year. By selling the exact same product at the
exact same price in foreign currency Microsoft reaped higher returns.
Stocks can be bought for risk-reducing reasons even if they are going
to be only average investments. This is an interesting turn of events.
Stocks are often thought of as the high-risk, potentially high-reward
investments. It may be that stocks have become average investments with
some risk-lowering features.
Another reason to buy stocks is the ability to avoid taxes legally. Both
capital gains and dividends are subject to low tax rates. In addition, it is
possible to build your own tax-advantaged mutual fund. The technique is
to own a lot of stocks and to make sure that before the year ends, you sell
enough of the losers so that your tax bill is zero. This feature of stocks
has always existed, but until recently it was not feasible for most people
because of high trading commissions. The online brokerage revolution
has made it possible to legally defer paying taxes on stock market gains
Just as a family loves all its children, even the ones who are not super-
stars, there are good reasons to own stocks even if they are going to be
only average investments.

Even If You Do Not Buy Any Stocks,
You Own a Lot of Stock

The final chapter of this book contains a summary of my recommenda-
tions for investing. For most people, my suggestion for stock investing
will be lower than that advocated by Wall Street. Imagine for a moment
Stocks 187

that you follow my advice, or decide for other reasons to invest a modest
amount in stocks. Now fast-forward 30 years to learn that stocks have
done fantastically over that time. In 2035 you are looking back at your
current financing decisions.
Many investors that I know have fantasies of having made huge bets at
just the right moment. One of my friends correctly predicted the surge in
biotech stocks in the late 1990s. He made some money on his invest-
ments, but missed much of the opportunity (some of the stocks he fol-
lowed went from $5 to over $100 in a year). Almost every conversation
with him includes discussing his fantasy of borrowing every dime possi-
ble and buying those biotech stocks for the entire ride. Many other
investors speak of similar dreams”betting against stocks during the bub-
ble days, buying after the terrorist attacks in 2001, and more.
Imagine our prudent stock investor who looks back on 30 years of
stock market gains. The fantasy will be that she or he had invested every
penny in stocks and made a ton of money. Even better, if time travel is
invented, perhaps our investor in 2035 can travel back in time and change
the investments. Wouldn™t it be great to look in your retirement account
some years from now to find that magically your financial decisions had
been altered so that you had made the perfect set of decisions?
In Back to the Future, Marty McFly also wishes that he could change
the world. Near the beginning of the film, he sees his mentor, the crazy
professor, shot down by terrorists. Wouldn™t it be great if he could go
back in time and change events so that the professor is prepared for the
attack? That is exactly what McFly does by warning the professor when
he is time traveling. Armed with this knowledge, the professor still gets
shot, but a bulletproof vest protects him.
So if U.S. stocks continue their 200-year run, we™ll wish we could go
back in time to adjust our financial decisions accordingly. The funny
thing is that when it comes to stocks, even if you don™t buy any stocks,
you will most likely participate in any continued stock market rally. I™ve
been making this point to my buddy Doug for years.
Doug was a college roommate who now runs a number of entrepre-
neurial businesses in Southern California (and has become quite a
188 Applying Science and Art to Bonds, Stocks, and Real Estate

surfer). He made a ton of money during the bubble years, in part by a
huge investment in Qualcomm. At one point during those euphoric days
Doug owned 8,000 shares of Qualcomm. He went out surfing one day
and came back to learn that during his two-hour surfing trip, the stock
had surged by over $70 a share. So in a morning of surfing, Doug™s
investment in one stock increased by over half a million dollars! Not bad.
Even after the bubble broke, Doug was still ahead on his stock pur-
chases. During 2001 and early 2002, I constantly urged him to trim his
stock holdings. “Do you think that stocks are going to decline further?”
Doug asked. I responded by saying that my advice was not based on a
prediction of the stock market. Frustrated, Doug said, “Why should I sell
stocks if they are going to go up?”
I had Doug then draw up a list of his assets. He was a rich guy worth
millions. This money was divided between California real estate, the
value of his businesses, and his stock holdings. I then asked him to
describe a scenario in which his businesses were in trouble. The answer
was that his businesses would suffer serious decline in a recession. The
final question was to ask Doug about the value of his stock and his real
estate in this scenario. The answer was that if the economic conditions
went south, all three of his major sources of wealth would decline
The conclusion was that even if Doug owned no stocks, his wealth
would go up along with a stock market rise. Doug participates in any
stock market boom even if he owns no stocks. His real estate and his
businesses are worth more in the good economic times that foster stock
market gains.
Similarly, most of us effectively own stocks even if we haven™t bought
any. Most importantly our job prospects probably go up and down with
the stock market. If we put most of our financial eggs into stocks then
precisely when we might need those resources because of problems in
our lives, they are likely to be less valuable.
Most of us need not fear missing a stock market rally. If events turn out


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