 Investing Noir
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By Scott
Lummer
Chief Investment Officer, mPower
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I was sitting in my office, reading my copy of the Journal,
when she walked in (virtually, through an e-mail). She was a gorgeous blonde (hey,
I assume all of the e-mails I get are from gorgeous blondes) with legs longer than the
most recent bull market and a header that was out of this world. She said, "I'm
looking for the Chief Investment Officer."
"That's me," I said.
"I want you to help me by answering a question."
"Shoot, doll face."
"Everyone says that stocks have a better return over
the long run than bonds. But after the tremendous run-up in stocks over the last 20 years,
is there a good chance bonds could do better than stocks over the next 20 years?"
I told her that I could look into it, and she asked what my
fees were.
"Ten bucks a day, plus stock options."
"Options in what?"
"I don't know, but this is northern California in the
year 2000, and everyone asks for stock options."
She told me she didn't have any options to give, but being
a sucker for a pretty font, I went ahead and took the case.
I looked into it and then told her that on the surface,
what she heard was right. The last time that bonds outperformed stocks over a 20-year
period was more than a half century ago: 1929 to 1948 to be specific. She then pointed out
that back then, readers might have been able to understand my convoluted writing style.
"Well what about the possible run-up?" she asked.
"After all, stocks have gone up by 29 percent per year over the past five years. If
stocks are currently overvalued, can't that affect future return?"
"Yes. But most, if not all, of that return is
justified by increases in efficiency in the economy."
"Can you explain why that has occurred?"
"No."
"Oh, because of confidentiality with another client on
a different case?"
"No, because I'm going on vacation in two weeks and
I'm running out of ideas for columns, so I'm saving that explanation for another
week."
"How can you be sure that the run-up won't create an
environment in which stocks will underperform bonds?"
I told her I would do some snooping around the data and
give her my findings. With that, she left my computer screen, but not before giving me a
wink that would stop a momentum investor cold.
I made some assumptions. Bonds are currently yielding 6
percent. A typical return on the stock market is about 6 percent more than bonds. So, a 12
percent annual return on stocks would be normal, which means over the past five years
stocks have earned a return of 17 percent per year in excess of what is normal.
Let's make another assumption. Say that about half (8
percent) of that excess return was justified by the economic environment, and the
remainder was caused by overexuberance on the part of investors. This would suggest that
the current level of the Dow (10,600 as I write this) is too high. If the market only
earned a 20 percent annual return, the Dow would be 7,300. Which means right now it's
overvalued by 46 percent.
If you invest in a market that is 46 percent overvalued and
hold onto stocks for 20 years, you would earn less than an expected 12 percent on stocks.
But this is not as little as you might think: Your annual return over the 20 years would
be 9.6 percent — which is less than 12 percent, but still far in excess of bonds.
I called her up and told her the news.
"Wow, am I ever impressed with your spreadsheet. But,
one question: If the market was even more overvalued, how much would it have to be
overvalued to create a return as low as bonds?"
A good analyst, like a good PI, always anticipates
questions (particularly if the conversation is all in his head), so I was ready with my
answer.
"The market would have to be overvalued by more than
1ý times to cause a return as little as 6 percent. This means that the true value of the
Dow would have to be only 4,000 to cause such a low return."
"So does that mean I have nothing to worry
about?" she asked.
"Not quite, blue eyes. Just because it seems unlikely
that the market will ever underperform bonds, nothing is impossible. Indeed, an analyst in
mid-1929 would have come to the same conclusion that I did. But, in actuality, stocks at
that time were overvalued by more than five times their true value. In this environment,
there is always the potential for disaster.
"So, even though it's unlikely that bonds will
outperform stocks any time soon, you may want to put a small portion of your money in
short-term bonds. Not because the market is overvalued, but because you will not be as
worried and are more likely to stick to a long-term investment plan."
She thanked me and paid me my fee ($1.25). I asked if she
would like to join me sometime for a drink and watch some CNBC.
"No, thank-you," she said.
"Oh," I said. "You're one of those clients
that flirt but walk away when the job is done."
"That's not it," she countered. "When I
wrote you I also had my own fantasies. But since then, the Kafý staff put your photo on
the site, and now I see what you really look like. I'm going back to 'Motley Fool' to
answer my questions."
Sometimes too much information is a bad thing.
 Lummer's Logic Archives
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