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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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The Great Crash could have been the basis of a major new era of U.S.How Triple Waterfalls Reshape the Landscape There is a bush saying about cooking firesThe bigger the fire, the bigger the fool. R. GRAVES CHICAGOS GREAT FIRE OF 1871, which burned most of the downtown and adjacent areas, did not derail the plans of its leading businessmen and visionaries. The city went on to achieve greatness beyond what even its most enthusiastic boosters would have expected in the days before the disaster struck. The catastrophe changed the city for the better, because a cadre of local geniuses looked on the burning ruins as the opportunity to lay out a model city that would be able to handle growth much better than the ramshackle and chaotic large/small town it had been before the fire. Triple Waterfalls create new opportunitiesfor the economy and for investors. They wipe out the previous financial landscape, destroying the vestiges of yesterdays bad ideas. They cleanse the economic environment. Because Romans loved to gorge themselves to excess for hours, they invented the vomitorium. One repaired to this chamber from time to time during a 15-course meal, to make space for new culinary delights. The Triple Waterfall is a grand financial vomitorium. It disgorges unneeded or obsolete assets and prepares the way for new production and consumption. (Lest the reader think the analogy breaks down because the retching Roman elites went to the vomitorium voluntarily, note that nobody had to buy technology and telecom stocks.) THE GREAT CRASH: 1926-1933 The Great Crash could have been the basis of a major new era of U.S. and global growth had (1) the Fed understood its role as central banker to the world, and (2) Congress passed a trade liberalization act, rather than the trade stultification of the Smoot-Hawley Tariff. This was a deflationary Papa Bear Crash, and what was needed immediately and for years thereafterwas reflationary and liberalizing policymaking. Churchill, who was in the wrong job as Britains Chancellor of the Exchequer, had kept Britain on the gold standard in 1926 (which he himself had restored the year before) when the overstressed nation should have devalued. Britain hung grimly on, devaluing only after the crash. The global banking situation was in serious trouble. Collapses began, culminating in May 1931 with the collapse of Credit-Anstallt. Although it was an Austrian bank that few Americans had ever heard of, its demise signaled a renewed intensification of the global crisis. It had the longer-range effect of weakening Austria relative to Germany, a weakness that would be exploited by Hitler in the Anschluss. Europe, which together with the United States was just about all of the industrial world at the time, was in debt (mostly to the United States) because of World War I. The American dollar was now the global standard, and what was needed to restore stability was a U.S. Current Account deficit, liquefying the debtor countries with dollars. Instead the world got the Smoot-Hawley Tariff. It had been introduced in Congress just before the Black Monday Crash in 1929 and helped trigger it, and was signed into law by President Herbert Hoover in 1930. Smoot-Hawley closed the U.S. market to imports from those debtor nations, forcing them into default and the world into depression. During the 1930s there were intervening equity rallies, but gold, gold mining shares, and long Treasury bonds were the winning investments in the deflationary decline that engulfed the world. What most Americans learned from this horror was the riskiness of equities. Thereafter, until the mid-1950s, stocks were valued on the basis of their dividends, and the attractive shares were those whose dividends were higher than Treasury yields. In other words, the Third Cascade of that Triple Waterfall lasted for roughly two decades. Stocks as an asset class underperformed bonds, gold, and real estate throughout the 1930s and did not begin trading as equities again for more than 25 years after the onset of the First Cascade of the crash. THE NIFTY FIFTY CRASH: 1972-1982 In contrast to 1929, the Crash of 1973-1974 was an inflationary Papa Bear event, driven by double-digit inflation and soaring commodity prices. (See Chart 3-1.) Monetary policy was disastrously expansive. The bubble that burst was the idea that stocks were good inflation hedges, and that a group of high-priced stocks could continue to earn lofty profits regardless of inflation or the state of the economy. That stocks are good hedges against modest, anticipated inflation is certainly true. If the CPI is going up 2 to 3 percent every year, companies can manage their pricing and their union contracts to stay ahead of inflation. Indeed, it is this aspect of corporate performance that makes equities cornerstones in the portfolio of retirees: Their portfolios value and their dividend income are expected to stay ahead of inflation. Unanticipated inflation is another matter. Among economists, Milton Friedman was virtually alone in expecting double-digit inflation; the populace was in shock, and manyif not mostU.S. corporations were hurt. To make matters much worse, that extreme inflation produced a deep recession; at that time, nearly all the experts except Friedman believed that inflation and recessions could not go together. So U.S. stocks were simultaneously hit with unanticipated inflation and unanticipated recession. The Nifty Fifty stocks were priced for perfection. Their price-earnings ratios were extremely high, because expectations of future earnings growth were extremely high. They had reached what analysts call the North Pole position, where your next step had to be down. When those glamour stocks went down, they pulled the entire stock market with them. They had sucked most of the air out of the stock market in the months before they entered their Triple Waterfall Crash, and there were few investorsother than the then relatively unknown Warren Buffettto buy the overlooked stocks. At the bottom, in December 1974, the p/e ratio on the Dow Industrials briefly registered below six. Investors had given up on stocks because the supposedly invulnerable stocks turned out to be the sickest in the whole market, and it was unclear who their successors would be. The thought was: better to put money into hard assets. That crash helped develop the inflation psyche that would be the defining characteristic of the 1970s. It triggered a rush into inflation-hedge assetsfarmland, coins, collectiblesand the three that together crashed during the Triple Waterfalls in the 1980sgold, silver, and oil. Inflation is partly monetary, partly driven by shortages of foods and fuels, and partly psychological. Short-term shocks like the oil boycott or the El Nio crop failures produce commodity price leaps, but only an excess of money and a generalized psychological acceptance of inflations inevitability make those shock effects permanent. The crash of the Nifty Fifty stocks came when exogenous forces those that come from outside the market, rather than the endogenous forces, which are problems and excesses within the market itselfshowed that the nature of that generations Shared Mistake was a culture that accepted fallacious arguments for these stocks high valuations. When IBM and Xerox were plunging and Homestake (a big gold mine) and Kerr-McGee (a big oil producer) were rising, the investment argument had been turned on its head. Although it was runaway inflation that ultimately destroyed the Nifty Fifty bull market, the bear market began with a noneconomic event. Mighty IBM lost at trial in an antitrust suit brought by a tiny competitor called Telex. Telex vs. IBM I recall that landmark lawsuit well. I was working as a rookie investment officer at the time, and was luckyor cheekyenough to challenge the prevailing consensus. My employer was a major Canadian life insurer, which owned a remarkably large position in IBM. The company had owned these shares since the Depression. It had bought and held them because of their high dividend yield. The imbedded capital gains were, of course, enormous, and each time the company had lightened up in the past, it regretted the sale, since IBM just kept reaching new peaks. I looked at the issues in IBMs antitrust suits with the Justice Department and with Telex. I had written my law journal article on an aspect of U.S. antitrust law. I went back and dug out the article and reviewed the landmark cases, then wrote a long memo to the finance committee, suggesting that IBMs chances of winning were no better than 60-40, and if it lost either suit, its shares would plunge. My boss liked the memo, but he expressed concern that the board would be upset unless I researched the matter much further. I was sent to Wall Street to interview the analysts who covered IBM at the leading firms who covered us. It took a week. Not one analyst thought there was a chance IBM could ever lose any lawsuit. They kept pointing out the odds: IBM had more than 200 top antitrust counsel on its side, whereas Telex had six or seven. I returned to report that the pricing of IBM shares allowed no chance for legal defeat. As a former trial lawyer, I also observed that having 200 lawyers might be a huge disadvantage. My employer agreed to sell one-third of its position. A week later Telex won round one of its case with IBM. There was a delayed opening of stocks that morning on the New York Stock Exchange, and IBM opened down heavily. The biggest bear market since 1929 had begun. Since luck is a big factor in almost all trials, that outcome was, for nearly everybody, a major piece of luck. Bad luck for IBM stockholders, bad luck for stock investors, but good luck for a wannabe senior investment officer. The Shared Mistake IBMs upset defeat was a textbook example of Shared Mistake. To assign 100 percent probability to the belief that IBM could keep winning every skirmish was a reflection of the awe in which it was held. Weeks before that demarche, The New Yorker ran a full-page cartoon that showed an old man on his huge deathbed, surrounded by evidences of wealth and by his family. He was gasping, Dont let them sell my IBM! (Earlier it had run another full-page cartoon that expressed the ethos of the giddy growth stock era. A man is shouting at his broker from a telephone booth. Across the road, a huge factory, labeled AMALGAMATED CHEMICAL is in flames. The caption reads, I dont care about its long-term growth prospects! Sell my Amalgamated Chemical!) So majestic and mighty was IBM that some investment counselors recommended that retired persons hold more than 50 percent of their savings in IBM shares. Their argument: Capital gains taxes are roughly half the rate of taxes on interest and dividends. IBM grows its earnings predictably 15 to 20 percent a year, and the stock price rises at least that fast, because the p/e ratio doesnt shrink. Therefore, just sell off part of your IBM holdings annually for current income and youll never outlive your savings. In reality, IBMs era of the magnificent mainframe was soon to come to an end. Apple Computer would change the game. IBMs share price today is below its 1973 peak (adjusted for inflation). There would never be another IBM, I thought. No company would ever acquire that mystique again. Fortunately for my clients and me, there was Microsoft. In 1999, I got another chance to dust off my law school notes. I advised clients that Microsoft had a good chance of losing its antitrust suit. Many clients rejected the advice. In essence their argument was, Microsoft is bigger than the governmenta sure sign of Shared Mistake. As with IBM a generation earlier, Microsofts defeat months later coincided with the First Cascade of the most recent Triple Waterfall Crash (discussed in The Nasdaq Crash: 1997 to ? below). Avon was another example of the power of a Nifty Fifty Shared Mistake. At its peak, Avon stock had a p/e ratio of 90. Avons unique business plan was personalized selling of cosmetics and personal care items through salespeople to women in their homes. Its signature of the ringing doorbell and Avon calling made it the very best kind of household word. It really worked superbly. If the lady of the house were at home. All those male portfolio managers who bid up Avon shares in 1970-1972 didnt think about the implications for the companys sales strategy when a large percentage of women reentered the work force after having their children. Avon calling became Avon falling as its shares plunged during the next 15 years. Then the company restructured itself and once again became a superb investment. The Nifty Fifty Triple Waterfall created investment opportunities in (1) the kinds of solid free-cash generators prized by Warren Buffett, such as Coca-Cola and Gillette, and (2) inflation-hedge companies, such as oil and gas producers, gold mines, agribusiness companies, base metals, and forest products. Meanwhile, an investor who had bought and held the shares of the Nifty Fifty in 1972 would have underperformed the stock market until the 1990s. Inflation hedges beat that portfolio in the 1970s, and the disinflation stocks (consumer growth and financial) beat it in the 1980s. So much for Buy and Hold. If youre holding a portfolio constructed on Triple Waterfall Fanaticism, you lose. Big. |
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