For The Cautiously Optimistic

Addison Wiggin - Tue 22 Jun, 2004

"...In a 2001 Barrons interview, Jeremy Grantham unveiled the conclusions he had drawn following an extensive study of market bubbles, including stocks, bonds, commodities and currencies - 28 bubbles in all. Grantham and his associates defined a bubble as "a 40-year event in which statistics went well beyond the norm, a two-standard-deviation event."..."

“Great bear markets take their time. In 1929, we started a 17-year bear market, succeeded by a 20-year bull market, followed in 1965 by another 17-year bear market, then an 18-year bull. Now we’re going to have a one-year bear market? It doesn’t seem very symmetrical.”

  - Jeremy Grantham, 2001


From time to time, we like to remind readers that markets, like all natural beasts, have a tendency to get out of whack. And, that nature, never too shy, likes to force them back into whack.

In a 2001 Barron’s interview, Jeremy Grantham unveiled the conclusions he had drawn following an extensive study of market bubbles, including stocks, bonds, commodities and currencies - 28 bubbles in all. Grantham and his associates defined a bubble as “a 40-year event in which statistics went well beyond the norm, a two-standard-deviation event.”

“Every one of the 28 [bubbles] went back to trend,” Grantham noted, “no exceptions, no new eras, not a single one that we can find in history.” It will come as no great surprise to Daily Reckoning pedants that we are prone to Mr Grantham’s influence. In fact, if you were a bully and you pressed our backs tightly up against a chain link fence, you’d sooner hear us squeal “Dow 3000” than 13,000... or even 12,000...

What may come as more of a surprise, in today’s essay, however, is a nod to optimism, albeit a cautious one. We have just put down friend and colleague John Mauldin’s new book: “Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market,” and would like to recommend that you buy a copy and read it. Today.

Firstly, Mr Mauldin argues forcefully, for six chapters, that we are in the early stages of a secular bear market in US stocks. The comprehensive coverage in those chapters alone makes us - purveyors of the longest daily e-mail in recorded e-history - feel like slackers.

Mauldin shows - citing studies that would make any market historian swoon - that when valuations reach the levels they are at today, investors have always been better off investing in money market funds over the following ten years. But what fun is that? After Mauldin gets done thoroughly discouraging his readers...he offers many a ray of hope. Cautiously, of course.

For example, John cites an article from the 2001 Academy of Sciences Journal of Financial Intermediation, in which a researcher by the name of Albert Wang found that neither “under-confident” investors nor perma-bearish sentiment could survive in the market. Massively “over-confident” or bullish investors likewise lead themselves to the slaughterhouse. Only the investors who are cautiously optimistic were able to not only survive, but also win.

“In the world of our ancestors,” Mauldin writes, “overconfidence will get you killed. Lack of confidence will mean you sit around and starve. Cautious optimism is the right approach. What Wang is showing is that the same is true in the new world of investments. It should be self-evident that it is necessary to play if you are going to win. Further, a willingness to accept some level of volatility and risk is characteristic of successful investing. But taking too much risk will soon get you sent to the sidelines.”

But the wrong type of “confidence” will get you killed just as quickly. As an example, let’s look at another study Mauldin has unearthed:

“First, a researcher takes a deck of 52 cards and holds one card up. Watchers pay a dollar for the chance to win $100 if that card is picked out of the deck. Keep in mind the expected payout is 1/52 × 100 = 1.92. Las Vegas would quickly go broke with such odds.

“Then they are asked if they would like to sell their chances: roughly 80 percent would sell if they could, asking for an average price of $1.86. If you could get such a price, it would be a reasonable purchase. For someone who could buy all 52 chances, it would be a good investment or arbitrage. He would make a quick 3.18 percent.

“Now it gets interesting. The next time, someone is allowed to pick a card out of the deck and offered the same chance, but now he has a personal attachment to the card because he touched it. Only about 60 percent of those who picked cards were willing to sell their chances, and they wanted an average price of just over $6. And when this same trick was performed at business schools, the average sale price has been over $9.

“‘I know this card. I have studied it. I have a personal involvement with the card; therefore it is worth more,’ thinks the investor. Of course, it is worth no more than in the first case, but the psychology of ‘owning’ the card makes investors value it more.”

Investors, Mauldin suggests, continually make that same mistake - substituting familiarity for value-based research and reason, basing their investments and their future on false confidence that, in the end, leads to disaster. You could substitute fund, market, country, currency, or metal for the word “share”. Just because we know a lot about an investment does not mean it is a good one.

But where then, does Mr Mauldin find the right kind of confidence? In a true sense, that search is the unstated theme of his book...and it comes from several sources.

First, it is the steady march of history. Mauldin sees the stock market, currencies, commodities, bonds, interest rates - in short, everything - as subject to historical, economic and fundamental forces. Finding these forces and investing with the trend - rather than against it - is the key to confidence. Where some might see the continued decline of the dollar as a reason to despair, John simply sees another trend from which to profit. If the economy grows slower than in the past - something Daily Reckoning readers will recognise as Mauldin’s ‘Muddle Through Economy’ - again it is not a problem, but an opportunity.

When central bankers want to manipulate interest rates - they may theoretically be wrong - but astute investors recognise it as a gift of potential personal profit. Every chapter of Mauldin’s book is grounded in history...yet he steps out on occasion and deigns to predict the future.

If you’re a regular reader of the Daily Reckoning, you know Mauldin believes that value is the driver of market cycles. In Bulls Eye Investing, he offers numerous ways that small investors - which he demonstrates have an inherent advantage over institutions in today’s market - can invest with confidence. His chapters on value investing may be considered as essential reading for the individual investor. Mauldin’s data mining on “behavioural investing” is worth an entire book of its own.

How can you be in the top 10% of all investors over the next ten years? Simple. Just be above average for each of the next ten years. You don’t have to shoot for the moon or take great risks. If you can beat the average - each and every year - in the end you will be among the most successful investors on the planet.

Regards,

Addison Wiggin
for the Daily Reckoning

P.S. If you’ve read our book you know there are, quite frankly, few occasions upon which we agree with George Gilder. But when he writes: “Mauldin is the Ben Graham of the new millennium, but unlike Graham, he combines investment savvy with a sense of humour and a gift of style,” we are tempted to do just that.