Bull Market Bull

I was about to write about John Mauldin’s Bull’s Eye Investing. Then it struck me. I now have enough of the pieces. I can see through a lot of today’s Bull Market Bull.

We have been told that prices don’t matter. We have been told to buy all stocks, all the time. We have even been told that “it is different this time” means exactly the opposite of what it was intended to mean.

This is Bull Market Bull.

Ben Graham, Warren Buffett and Sir John Templeton have told us that prices matter. They buy stocks only when it makes sense to buy stocks. They vary their stock allocations with valuations.

We have been told that index funds do better than almost all of the actively managed mutual funds and that they always will. We have been told that no one can consistently select stocks that will beat the market. We have been told that nobody can time the market in any way whatsoever.

All of this is Bull Market Bull.

Here is the dirty little secret: For all intents and purposes, our mutual fund data only goes back to 1980. All of those academic studies that tout the superiority of passively managed index funds tell us only about the longest and strongest bull market in US history (1982-2000).

This is the proper conclusion: During a bull market, buy everything and cut costs to the bone. Never sell. Buy and hold.

What about other times? The academics have nothing to tell us. They have lots of data points, but those are bull market data points.

Warren Buffett gave a talk at Columbia University in 1984. He called it The Super Investors of Graham-and-Doddsville. He showed that he was able to identify ahead of time a widely diverse group of investors who consistently beat the market by a large margin. They differed in all respects except this: they had the right temperament for investing and they understood value.

Warren Buffett challenged the academics and they failed miserably. They have not even tried to explain how he was able to select such a group. It does not fit in with their theories.

Ben Graham separated decisions based on PRICE from those associated with MARKET TIMING. It is true that year-to-year price variations are almost random. It is true that the overall annualized total return of the stock market over the very long-term is highly predictable, almost certain.

What is NOT true is that prices are entirely random. What is NOT true is that prices have no relationship to value. Prices do NOT follow a random walk (in the sense that past prices make no difference).

Prices are, in fact, related to earnings, albeit loosely. The likelihood of a price increase or decrease depends upon its relationship with (smoothed) earnings. Although we cannot identify the exact dates, we can discern what is likely in the intermediate-term (5 to 20 years, usually close to 10 years).

We know that valuations are exceedingly high. Even today they are higher than their pre-bubble peaks. History and theory tell us to expect price-to-earnings multiples to contract. After all, why pay a premium and take risks for an income stream (from dividends) that is inferior and will continue to be inferior to the money market?

It is likely to take a long time (a decade or more) to reach bottom. We are in a secular (i.e., long lasting) bear market.

Beware of Bull Market Bull.

What about those academic studies searching for management skill that never found any? There is a story here. It is a scandal. A major league scandal. Those studies couldn’t find anything. The academics did not think about the power of their statistical tests. [This is known as the type 2 error.] Their threshold was to beat the market by more than 5.8% every year for 14 years. They didn’t see anything because they couldn’t see anything.

How about today?

This is the proper conclusion for today: During a bear market, be cautious. Be patient. Sit on the sidelines if necessary. Demand value. Wait for your price. Keep your costs down.

Price discipline will be incredibly important.

Buy and hold will give way to Ben Graham’s willingness to sell a stock when the market offered him a ridiculously high price. It makes sense to allow allocations to vary as valuations change.

It is important to know your own needs. A reliable and adequate stream of dividend income can isolate you from price fluctuations. The Government guarantee for TIPS and I Bonds can protect you from experiencing the worst effects of inflation.

Bear markets are choppy markets. There are as many years with big price increases as there are with big price decreases. The overall trend is down. Although this is arguable, I expect index funds to lose much of their luster as they drift downward and sideways in this bear market. I predict that academics will discover that there really is such a thing as management skill.

Have fun.

John Walter Russell
I wrote this on June 8, 2005.