The Death of Equities, Revisited

A recent article appearing in the Financial Times caught our eye—or perhaps we should say ear. At first glance it was unremarkable—just one among dozens of recent think pieces suggesting that investors were losing interest in stocks as markets around the world continued to stagnate.

But the tone of the article sounded remarkably familiar. We dug out our copy of the "Death of Equities" article appearing in BusinessWeek on August 13, 1979, to have a fresh look. Similar? You be the judge:

BusinessWeek, 1979:
"This 'death of equity' can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than ten years through market rallies, business cycles, recession, recoveries, and booms."
Financial Times, 2012:
"Stocks have not been so far out of favor for half a century. Many declare the 'cult of the equity' dead."

BusinessWeek, 1979:
"Individuals who are not gobbling up hard assets are flocking to money market funds to nail down high rates, or into municipal bonds to escape heavy taxes on inflated incomes."
Financial Times, 2012:
"The pressure to cut equity exposure is being felt across the savings industry. … In the US, inflows to bond funds have exceeded equity inflows every year since 2007, with outright net redemptions from equity funds in each of the past five years."

BusinessWeek, 1979:
"Few corporations can find buyers for their stocks, forcing them to add debt to a point where balance sheets seem permanently out of whack."
Financial Times, 2012:
"With equity financing expensive, many companies are opting to raise debt instead, or to retire equity."

BusinessWeek, 1979:
"We have entered a new financial age. The old rules no longer apply." —Quotation attributed to Alan B. Coleman, dean of business school, Southern Methodist University
Financial Times, 2012:
"The rules of the game have changed." —Quotation attributed to Andreas Utermann, Allianz Insurance

BusinessWeek, 1979:
"Today, the old attitude of buying solid stocks as a cornerstone for one's life savings and retirement has simply disappeared."
Financial Times, 2012:
"Few people doubt, however, that the old cult of the equity—which steered long-term savers into loading their portfolios with shares—has died."

When the first "Death of Equities" article appeared, the S&P 500 had underperformed one-month Treasury bills on a total return basis for the fourteen-year period ending July 31, 1979 (107.0% vs. 119.6%, respectively). Was buying stocks in August 1979 a smart contrarian strategy? Yes, but only if one had the patience to stick it out for years. Imagine the frustration of an investor who had been counseled to "stay the course" in response to the "Death of Equities" article appearing in August 1979. Stocks did well for a while, jumping over 27% from August 13, 1979, to March 25, 1981, when the S&P 500 hit an all-time high of 137.11. But by July 31, 1982, stocks had given back all their gains, and the S&P 500 was almost exactly where it had been nearly three years earlier. As of July 31, the S&P 500 had extended its underperformance relative to one-month Treasury bills to seventeen years (total return of 150.5% vs. 213.6%).

Imagine this same investor arriving at her financial advisor's office on Friday, August 13, 1982, with a three-year-old copy of BusinessWeek under her arm. Stocks had drifted lower in the preceding weeks, and the S&P 500 had closed the previous day at 102.42. "You told me three years ago to stay the course, and I did," she might have remarked to her advisor. "It hasn't worked. Obviously, the world has changed, and it's time I changed too. Enough is enough."

We suspect even the most capable advisor would have faced a big challenge in seeking to persuade this investor to maintain a significant equity allocation. For many investors, seventeen years is not the long term, it's an eternity.

Superstitions aside, stocks rose that day, with the S&P 500 advancing 1.4%. It wasn't obvious at the time, but August 13, 1982, marked the first day of what would turn out to be one of the longest and strongest bull markets in US history. The S&P 500 was 16% higher by the end of the month and went on to quadruple over the subsequent decade. The table below shows data for the S&P 500 on a price-only basis. With dividends reinvested, the return would be materially enhanced.

"Death of Equities" Anniversary
1st Anniversary	August 12, 1983	58.3%
5th Anniversary	August 12, 1987	224.5%
10th Anniversary	August 12, 1992	307.9%
20th Anniversary	August 12, 2002	782.4%
(Almost) 30th Anniversary	June 19, 2012	1,225.9%

One of the authors of the FT article, John Authers, is familiar with the BusinessWeek article and wary of making pronouncements that might look equally foolish ten or twenty years hence. In a follow-up article appearing several days after the first, he appealed for divine assistance in his forecasting effort: "O Lord, save me from becoming a contrarian indicator." Nevertheless, after revisiting his arguments he remained persuaded that the climate for equities was too hostile to be appealing.

We should not use this discussion to make an argument that stocks are sure to provide investors with appealing returns if they just wait long enough. If stocks are genuinely risky (which certainly seems to be the case) there is no time period—even measured in decades—over which we can be assured of receiving a positive result. Nor should we seize on every pundit's forecast as a reliable contrarian indicator. With dozens of self-appointed experts making predictions, some of them are going to be right. Perhaps even John Authers.

The notion that risk and return are related is so simple and so widely acknowledged that it hardly seems worth arguing about. But these articles (and others of their ilk) offer compelling evidence that applying this principle year-in and year-out is a challenge that few investors can meet, and explains why so many fail to achieve all the returns that markets have to offer.

---

References

"The Death of Equities," BusinessWeek, August 13, 1979.
John Authers and Kate Burgess, "Out of Stock," Financial Times, May 24, 2012.
John Authers, "The Cult of Equities Is Dead. Long Live Equities," Financial Times, May 27, 2012.
S&P data are provided by Standard & Poor's Index Services Group.
Stocks, Bonds, Bills, and Inflation Yearbook. Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).

Climbing a Wall of Worry

The surge in stock prices around the world in the first quarter serves as a reminder that predicting market trends can be a frustrating business. Six months ago, the outlook for stock prices appeared to be fading from grim to grimmer: Congressional leaders were wrangling unsuccessfully to craft a deficit reduction plan, Standard & Poor’s had removed its AAA rating on US Treasury obligations, and Greece appeared one step away from defaulting on its debt.

Yet just when many investors least expected it, stocks staged a powerful rally: From the low for the year on October 3, the S&P 500 Index rebounded 28.1% through March 30 while the Russell 2000 Index jumped 36.2%. As the news excerpts below suggest, it is worth recalling the Wall Street adage that "bull markets climb a wall of worry."

• August 5, 2011—S&P downgrades US Treasury debt to AA+ from AAA; stocks plunge in the biggest sell off since 2008.
• September 3, 2011—Journalist: "The US economy slammed into a wall in August, failing to add new jobs for the first time in nearly a year."
• September 5, 2011—Gold reaches a record high of $1,895 per oz. (London Fix).
• September 19, 2011—Wall Street chief equity strategist: "I don’t think we’ve seen the lows for the year by any stretch. Things have to get much worse before they get better."
• September 23, 2011—Journalist: "The world economy once again stands on a precipice."
• September 26, 2011—Investor: "I don’t see anything changing in the next two or three years."
• October 1, 2011—Economist cover story: "Unless politicians act more boldly, the world economy will keep heading towards a black hole."
• October 3, 2011—US stock prices slump to their lows of the year: 1099.23 for the S&P 500 and 609.49 for the Russell 2000 Index.
• October 13, 2011—Census Bureau reports the weakest income growth over a ten-year period since records began in 1967.
• October 20, 2011—Col. Muammar el-Qaddafi killed by Libyan rebel forces.
• November 20, 2011—Consumer goods CEO: "Consumers everywhere continue to be cautious and hesitant to spend."
• November 21, 2011—US Congressional "supercommittee" fails to reach deficit reduction agreement.
• November 24, 2011—Market strategist: "Earnings growth is very quickly decelerating."
• November 28, 2011—Moody’s Investors Service warns that multiple countries could default on their debt.
• November 29, 2011—AMR Corp., parent of American Airlines, files for bankruptcy.
• December 10, 2011—Detroit’s mayor predicts the city will run out of cash by April 2012.
• January 6, 2012—Gasoline prices are at the highest point ever for a new year.
• January 18, 2012—World Bank: "Developed and developing-country growth rates could fall by as much or more than in 2008–09."
• January 18, 2012—Eastman Kodak files for bankruptcy.
• January 25, 2012—Report from Davos World Economic Forum: "Global elite fears renewed downturn."
• February 13, 2012—Journalist: "There is still plenty that could go wrong in Europe, while U.S. economic growth remains slow and corporate earnings are looking less and less robust."
• February 27, 2012—Money manager: "This is a business-as-usual overpriced market and you’ll get a zero return for seven years."
• March 2, 2012—Eurostat reports that Eurozone unemployment in January reached 10.7%, the highest in fifteen years.
• March 12, 2012—Strategist: "The stock market has effectively doubled since the March ‘09 low, and we’re still in redemption territory for equity funds."
• March 19, 2012—Journalist: "Expectations for earnings have been steadily scaled back this year, as the mood among companies has worsened."

---

References

E.S. Browning, "Downgrade Ignites a Global Selloff," Wall Street Journal, August 9, 2011.
Sudeep Reddy, "Job Growth Grinds to a Halt," Wall Street Journal, September 3, 2011.
Quotation from Adam Parker, chief US equity strategist Morgan Stanley. Jonathan Cheng, "Wall Street’s Optimism Fades," Wall Street Journal, September 19, 2011.
Chris Giles, "Financial Institutions Stare into the Abyss," Financial Times, September 22, 2011.
Tom Lauricella, "Pivot Point: Investors Lose Faith in Stocks," Wall Street Journal, September 26, 2011.
"Be Afraid," Economist, October 1, 2011.
Phil Izzo, "Bleak News for Americans’ Income," Wall Street Journal, October 13, 2011.
Kareem Fahim, "Qaddafi, Seized by Foes, Meets a Violent End," New York Times, October 21, 2011.
Quotation from Jim Skinner, chief executive of McDonald’s. Jeff Sommer, "From the Mouths of Executives, Little Comfort," New York Times, November 20, 2011.
Jonathan Cheng and Brendan Conway, "Panel’s Failure Sinks Stocks," Wall Street Journal, November 21, 2011.
Quotation from David Rosenberg, chief market strategist, Gluskin Sheff & Associates. Tom Petruno, "Wall Street Gets Cautious on Earnings," Los Angeles Times, November 24, 2011.
Brendan Conway and Steven Russolillo, "No Year-End Stock Surge in Sight," Wall Street Journal, November 26, 2011.
Liz Alderman and Stephen Castle, "Dire Warnings Are Building on European Debt Crisis," New York Times, November 29, 2011.
"Nowhere to Run—The Motor City Flirts with Fiscal Disaster," Economist, December 10, 2011.
Ronald D. White, "Gas Prices Ring in 2012 at a High," Los Angeles Times, January 6, 2012.
Chris Giles, "World Bank Warns on the Risk of Global Economic Meltdown," Financial Times, January 18, 2012.
Chris Giles, "Pessimism Hangs in Mountain Air," Financial Times, January 25, 2012.
Tom Lauricella and Jonathan Cheng, "Too Late to Jump Aboard?" Wall Street Journal, February 13, 2012.
Ajay Makan, "S&P 500 at Post-Crisis Peak but Investors Remain Wary," Financial Times, February 25, 2012.
Quotation from Jeremy Grantham, chief investment strategist, GMO. Leslie P. Norton, "Not So fast: Coping with Slow Growth," Barron’s, February 27, 2012.
Brian Blackstone, "Poor Economic Data Slam Europe," Wall Street Journal, March 2, 2012.
Quotation from Liz Ann Sonders, chief investment strategist, Charles Schwab. Nikolaj Gammeltoft, Inyoun Hwang, and Whitney Kisling, "The Bull Turns Three. Where’s the Party?" BusinessWeek, March 12, 2012.
Ajay Makan, "Wall Street Braces For Hit to Soaring Markets," Financial Times, March 19, 2012.

Who Has the Midas Touch?

Over the course of a lengthy and illustrious business career, Warren Buffett has offered thoughtful opinions on a wide variety of investment-related issues—executive compensation, accounting standards, high-yield bonds, derivatives, stock options, and so on.

In regard to gold and its investment merits, however, Buffett has had little to say—at least in the pages of his annual shareholder letter. We searched through 34 years' worth of Berkshire Hathaway annual reports and were hard-pressed to find any mention of the subject whatsoever. The closest we came was a rueful acknowledgement from Buffett in early 1980 that Berkshire's book value, when expressed in gold bullion terms, had shown no increase from year-end 1964 to year-end 1979.

Buffett appeared vexed that his diligent efforts to grow Berkshire's business value over a fifteen-year period had been matched stride for stride by a lump of shiny metal requiring no business acumen at all. He promised his shareholders he would continue to do his best but warned, "You should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway."

As it turned out, the ink was barely dry on this gloomy assessment when gold began a lengthy period of decline that tested the conviction of even its most fervent devotees. Fifteen years later, gold prices were 25% lower, and even after twenty-one years (1980–2010), had failed to keep pace with rising consumer prices. By year-end 2011, gold's appreciation over twenty-two years finally exceeded the rate of inflation (205% vs. 195%) but still trailed well behind the total return on one-month Treasury bills (398%).

Perhaps to compensate for his past reticence on the subject, Buffett has devoted a considerable portion of his forthcoming shareholder letter (usually released in mid-March) to the merits of gold.
With his customary gift for explaining complex issues in the simplest manner, Buffett deftly presents a two-pronged argument. Like a sympathetic talk show host, he quickly acknowledges the darkest fears among gold enthusiasts—the prospect of currency manipulation and persistent inflation. He points out that the US dollar has lost 86% of its value since he took control of Berkshire Hathaway in 1965 and states unequivocally, "I do not like currency-based investments."

But where gold advocates see a safe harbor, Buffett sees just a different set of rocks to crash into. Since gold generates no return, the only source of appreciation for today's anxious purchaser is the buyer of tomorrow who is even more fearful.

Buffett completes the argument by asking the reader to compare the long-run potential of two portfolios. The first holds all the gold in the world (worth roughly $9.6 trillion) while the second owns all the cropland in America plus the equivalent of sixteen ExxonMobils plus $1 trillion for "walking around money." Brushing aside the squabbles over monetary theory, Buffett calmly points out that the first portfolio will produce absolutely nothing over the next century while the second will generate a river of corn, cotton, and petroleum products. People will exchange their labor for these goods regardless of whether the currency is "gold, seashells, or shark's teeth." (Nobel laureate Milton Friedman has pointed out that Yap Islanders got along very well with a currency consisting of enormous stone wheels that were rarely moved.)

When Buffett assumed control of Berkshire Hathaway in 1965, the book value was $19 per share, or roughly half an ounce of gold. Using the cash flow from existing businesses and reinvesting in new ones, Berkshire has grown into a substantial enterprise with a book value at year-end 2010 of $95,453 per share. The half-ounce of gold is still a half-ounce and has never generated a dime that could have been invested in more gold.

Few of us can hope to duplicate Buffett's record of business success, but the underlying principles of reinvestment and compound interest require no special knowledge. Every financial professional can point to individuals who have accumulated substantial real wealth from investment in farms, businesses, or real estate, and sometimes the success stories turn up in unlikely places. (See "The Millionaire Next Door.")

Where are the fortunes created from gold?

---

References

Weston Wellington, Down to the Wire, VP Dimensional
Warren Buffett, "Warren Buffett: Why Stocks Beat Gold and Bonds," Fortune, February 27, 2012. Available at: http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/.
Milton Friedman, Money Mischief (Boston: Houghton Mifflin Harcourt, February 1992).
Stocks, Bonds, Bills and Inflation, March 2011.
Bloomberg.
Berkshire Hathaway Inc. Available at: www.berkshirehathawy.com (accessed February 21, 2012).

What Does a Winning Streak Tell Us?

Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection.

Miller's most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron's included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as "one of the greatest investors of our time." A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to "think about thinking" suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.

Miller's bold and concentrated investment style would never be confused with a "closet index" approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller's overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?

Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.

Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund's expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund's performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion's share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.

To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.

Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.

Commentators have said that Miller has "lost his touch" or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.

Where does this leave investors seeking the best strategy to grow their savings?

When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, "As William James would say, we can't really draw any final conclusions about anything." Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.

---

REFERENCES
Weston Wellington, VP, Dimensional
Andy Serwer, "Will the Streak Be Unbroken," Fortune, November 27, 2006.
Edward Wyatt, "To Beat the Market, Hire a Philosopher," New York Times, January 10, 1999.
Tom Sullivan, "It's Miller Time," Barron's, October 12, 2009.
Diana B. Henriques, "Legg Mason Luminary Shifts Role," New York Times, November 18, 2011.
Standard & Poor's
Morningstar Inc.

What's in Your View Finder?

Below is a very intriguing article written by Weston Wellington, VP, Dimensional.  I thought it was worth sharing and I hope you find wisdom in reading it.

He is no longer with us, and the world is poorer for it.

A restless college dropout, he founded a wildly successful company whose innovative products touched millions of lives. He was a brilliant, dictatorial, and cantankerous leader, relentlessly pushing his staff to solve one impossible problem after another. He had no use for conventional market research, and trusted his own vision to create products with little detectable demand that flew off the shelves upon introduction. He zealously guarded his personal privacy but reveled in his role as a master magician on stage when introducing his firm's latest innovations to eager crowds of industry followers. Stockholders wore big smiles as the shares vaulted to one new high after another. In many ways, he was the antithesis of the conventional corporate chieftain, and despite his demanding persona, he was revered by employees, customers, and even competitors to a greater extent than almost any other chief executive in recent memory.

A tribute to the late Steve Jobs? No—to Edwin Land of Polaroid.

The son of a scrap metal dealer, Land dropped out of Harvard to pursue his own research at the New York Public Library on polarized light filters. He founded Land-Wheelwright Laboratories in 1934 with his former physics professor, and his low-cost polarizing filters proved useful in products ranging from sunglasses to army tank telescopes and gunsights. After the war, he turned his attention to photography and introduced the Polaroid-Land instant camera in 1948. Despite a stiff price tag of $89.75 the first shipment of 57 cameras sold out in a matter of hours at a Boston department store, and the firm never looked back.

Numerous improvements followed, and sales boomed as the cameras and film became smaller, lighter, easier to use, and less expensive. The stock price did likewise, and Polaroid became a bellwether "glamour" stock during the postwar bull market, soaring tenfold in just five years from 1963 to 1967.

When a cover story in Time appeared in June 1972, Polaroid seemed all but unstoppable. Land's inventive genius had resulted in an astonishing new industry with technology protected by a wall of over 1,000 patents. (Land himself held 535 patents, second only to Thomas Edison.) Eastman Kodak offered only token competition in instant photography, and was eventually vanquished in both the marketplace and the courtroom. Kodak was forced to pay Polaroid nearly $1 billion to settle a patent infringement suit and withdrew from the instant camera business. Polaroid shares reached an all-time high of $149.50 in mid-1972, amid intense excitement over the ingenious new SX-70 single lens reflex color camera and rumors of an instant movie product. Government surveys at the time identified photography as one of the fastest-growing industries in the country, and Polaroid appeared to be a key beneficiary: In the premium category (cameras selling for $50 or more), Polaroid was not only the undisputed leader but outsold all other global competitors combined.

Land was one of Steve Jobs' heroes, and the youthful computer tinkerer from California felt almost a mystical connection with the Cambridge scientist forty-six years his senior. Both were impatient perfectionists, often driving themselves even harder than their overworked employees. Land was infamous for wearing out staff members, who rotated in shifts while he focused on knotty problems. During one marathon research session, Land wore the same clothes for eighteen straight days. When Jobs had the opportunity to meet Land personally, he found that he and Land shared a peculiar characteristic: Both believed that new products were not invented so much as discovered. Both could visualize a product that did not yet exist down to its smallest details, and the task of development was thus akin to Michelangelo's description of sculpture: The artist's task was to remove the unnecessary material to reveal the beauty already contained within the stone.

Alas, Time's cover story marked the beginning of the end. The instant movie project ("Polavision") turned out to be a costly failure and led to Land's resignation in 1980. Jobs was dismayed when Land was pressured to leave the firm he had founded, calling him a "national treasure." Jobs would suffer a similar fate after a losing boardroom battle in 1985.

Although Polaroid products continued to sell well, the shift to digital photography caught the firm unprepared and slowly hollowed out the highly profitable film business. Polaroid filed for bankruptcy in October 2001. The research labs and film factories were shuttered, although the brand name, traded from one sharp-elbowed financier to another, survives as a ghostly reminder of its illustrious past. The years have been kinder to Eastman Kodak, but not by much. Founded long before Polaroid in 1888, it has outlived its former adversary but now struggles to avoid a similar fate.

What is the message for investors?

As we observed in a previous note, the forces of competition are relentless, and today's astonishing innovation may be tomorrow's commodity—or garage sale castoff. We have no reason to believe that Apple has anything but a bright future, but those of us tempted to concentrate our investment capital in a handful of exciting industry leaders should consider the fate of Polaroid before declaring, "It can't happen here."

---

Securities Research Company, SRC Green Book, 1993 edition.
"Polaroid's Big Gamble on Small Cameras," Time, June 26, 1972.
"The Story of Polaroid Inventor Edwin Land, One of Steve Jobs' Biggest Heroes," 37signals www.37signals.com, accessed October 14, 2011.