THE LIOKOSSIS LETTER Overview of Investment Fundamentals SPECIAL REPORT 2005 “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” - Ludwig von Mises, Human Action, A Treatise of Economics, 1949 This report is divided into three parts. In Part one we discuss how the stock market moves in giant cycles averaging 15-20 years in length and how, in my opinion, we are in the early stages of a long bear market. Part two summarizes the compelling evidence that supports this thesis. Part three looks at what history tells us will be the contrarian investments that should do extremely well during these difficult times. This document is intended as a guide to constructing a portfolio for the next decade, not the next 12 months. Although predicting the future is impossible, the themes discussed here are very long-term trends that are already well under way. At various times I will use the term “financial assets”. This refers to all stocks other than those of physical assets such as oil, gas, base metals, precious metals, timberland etc. PART ONE - THE CYCLE OF THE MARKET The cycle of the stock market can be distilled down to a very simple process. Bull markets, once born, last many years and reach absurd valuation levels. Bear markets also last years and do not end until stocks are selling for bargain prices. Then the whole process repeats itself, again and again. Look at the last 100+ years of the market: Market Cycle # Of Years Bull or Gain (+) Period (DJIA) Bear Market Lasted or Loss (-) 1900-1929 29 + 702% 1929-1949 20 - 48% 1949-1966 17 + 402% 1966-1982 17 - 22% 1982-2000 18 +1,402% 2000-2004 5 (so far) - 8% Source: djindexes.com, Jan. 2005 Table 1 2 In each case, a big up cycle was followed by a big down cycle. So far, the bigger the up cycle, the bigger the down cycle. In 2000 we finished the biggest up cycle of them all, 19 years and a 1,400% (djindexes.com, Jan. 2005) gain. Looking at Table 1, does it fit with history that this bear market is over after only five years and all of –8%? Think of the market as a pendulum. One end of the arc represents the peak of a bull market. At the other end is the trough of a bear market. The pendulum spends very little time at the mid-point of the arc, where stocks are fairly valued and the average rate of return is about 10% per year. It would be nice if markets delivered a nice, round 10% per year every year but they don’t. Once you understand this concept, you will have a framework that puts things into context. For example, the market today is at the same level it was roughly 6 years ago. This is confusing for investors who were conditioned by the 1990s to expect 20% gains every year. However, it makes perfect sense if you look at the big picture. The market topped out in 2000 with the bursting of the technology bubble, after an almost 20 year rise from the depths of pessimism in 1981. That was one swing of the pendulum. Now we are working our way back to cheaper stock valuations from which we can begin a new bull market. With this perspective, it makes sense that the process will take years and much pain before it is over. These last few years are the first tough times ever seen by two generations of investors. They have no idea what is going on and they certainly are not counting on another 5 or 10 or 15 years of this. Look again at Table 1 and note the length of the cycles. Each expansion and contraction lasted 15-20 years. Because a complete cycle takes so long to unfold, there is always a new generation of investors who are experiencing it for the first time. Each generation learns the hard way, through experience. It takes a while for a big change in the market to register with most investors. They do not want to believe it, even in the face of mounting evidence to the contrary. So if you have a 25-year time horizon, no problem. But if you are two years from retirement and your advisor uses net return assumptions of 10% for stocks, 7% for bonds and 2% for inflation for the next 10 years, you might want to ask some questions. If we are in a long bear market with accelerating inflation, investing based upon the conditions of the last 25 years is not going to work. It is worthwhile considering an alternative. PART TWO – EVIDENCE OF A LONG BEAR MARKET All the ingredients necessary for a massive bull market were strongly present in 1981 and it’s no surprise they spawned the mother of all bulls. Collectively, we had very high inflation, sky-high interest rates, big dividend yields on stocks and rock bottom stock valuations. Furthermore, the market had done poorly for many years leading up to 1981. In other words, conditions had reached their nadir and stock returns were set to improve dramatically. The Liokossis Letter, Special Report, 2005 3 Inflation and interest rates had nowhere to go but down and high dividends complimented robust capital gains from depressed stocks that had nowhere to go but up. Today, all these factors are stacked against us. Inflation has been low and is now accelerating, interest rates are already low and have begun to climb, dividend yields on stocks are poor by historical standards and stocks are extremely overvalued. These are very stiff headwinds facing the market, fundamental forces that reflect deep dislocations in the markets and the economy and they will take a lot of pain and many years to fix. Let’s look at the evidence. 1. PRICE / EARNINGS RATIO (P/E) The price/earnings ratio (P/E) is one of the simplest measures of whether a stock is overvalued or undervalued. Divide a company’s share price by the earnings per share and you get the P/E. A company that trades for $20 per share that earned $1.00 in the last 12 months has a P/E of 20. The higher the number, the more expensive is the stock and the less likely you are to make money on it. This measure can be applied to an entire market by taking the average of the P/Es of all the stocks in the index. There are many other measures we can use but they all tell pretty much the same story. As we entered 2005, the P/E on the S&P 500 Index was 20.6 (Source: Standard & Poor’s (standardandpoors.com), Jan. 2005) and the P/E on Canada’s TSX Index was at 18.8 (Source: TSX Group (TSE.com), Jan. 2005). These numbers by themselves don’t tell you much unless you know how high is high, and these numbers are sky high. Table 2 below shows you what an investment in the S&P 500 Index earned over the ten-year period after it reached a P/E of 20 or more (like where it is today): Starting Starting Annual Gain (+) or Loss (-) Year P/E Over the Next Decade 1902 22.0 +1% 1928 21.8 -3% 1929 27.6 -9% 1930 21.5 -6% 1961 20.5 +3% 1963 20.3 +5% 1964 22.6 +3% 1965 23.3 -1% 1966 21.3 +0% 1967 21.6 +1% 1968 21.5 +0% 1993 20.7 +9% Source: Crestmont Research(1), Jan. 2005 Table 2 Historically, anyone investing in a market when it is this expensive will tend to do very poorly over the next 10-20 years (yes, years). The Liokossis Letter, Special Report, 2005 4 Looking at Table 2, it all fits well until we get to 1993, where the following decade produced a respectable 9% per annum. Here the rule suddenly seems to break down. In reality this is a warning sign that things have gotten really out of hand. On several occasions after 1993, there occurred spectacular events in world markets that would likely have acted as catalysts for a market downturn. These events include the Asian currency crisis of 1997, the Russian 1998 debt default that precipitated the collapse of the giant hedge fund Long Term Capital Management and, most obviously, the collapse of the technology bubble in early 2000. However, what we got in response to each of these events was massive, historically unprecedented monetary stimulus by the U.S. Federal Reserve under Alan Greenspan. While successful in re-floating the markets and staving off potential catastrophes, what they have done is exacerbate the conditions that led to these crises in the fist place. In so doing they have delayed the inevitable and created a situation where the downside, when it comes, will be much worse than it would otherwise have been. Another way to look at this is that since 2000, despite truly breathtaking monetary and fiscal stimulus and debt accumulation, the market still hasn’t taken off. It’s a sign of a very unhealthy and unbalanced economy. To put a P/E of 20 into perspective, the Dow Jones Industrial Average reached 20.1 just before the Great Crash of 1929, it was 15.5 before the 1973/74 meltdown that devastated so many investors, it was 20.3 the month before the crash of 1987 and the P/E reached 27 in January 2000, just before the technology bubble blew up*.