Comment on Chapter 3

 bull market Hypocrisy

this chapter, Graham shows just how prescient he could be. He looked two years ahead and predicted the 'catastrophic bear market' of 1973-1974, when US stock prices fell 37% of their value. He looked more than two decades into the future, blowing away the predictions of market gurus and their bestselling books, which were not even on the horizon in his lifetime.The core of Prahm's argument is that the intelligent investor should never predict the future, especially after looking at past data. Unfortunately, that was the mistake that successive experts made in the 1990s. Numerous bullish books, such as Carleton finance proponent Jeremy Sougal's Stocks for the Long Run (1994), as well as James Plassman and Tin Taiset's Dow 36,000, David Elias' Dow 40,000, and Charles Cadilet's Dow 100,000 (all published in 1999), are themselves Wikiversity. The forecasters argue that stocks have returned to the annual average of post-inflation growth in 1992. Therefore, they conclude that investors should expect the same in the future.Some booms have lasted longer. Since stocks have 'always' beaten bonds over any period of at least 30 years, stocks must be less risky than funds or bank deposits. And if you hold on to bonds half the time and want to eliminate the risk of owning them, why do you care about what you paid for them in the first place? In 1999 and early 2000, the hypocrisy of the bull market was cracked.

• On December 7, 1999, Firstland Mutual Funds portfolio manager Kevin Landis appeared on CNN's Moneyline TV program. When asked if wireless telecommunications stocks were overvalued, despite trading at several times higher than their earnings, Landis had a ready answer. "It's not a mania, it's a clear uptrend, look at the net worth of growth. It's up so much," he retorted.

• 4 On January 18, 2000, Robert Fallick, chief investment strategist at Camper Funds, declared in the Wall Street Journal, "This is the new world order. What we've seen is that people don't buy good companies, run by good people, with the right vision, just because the price is too high. That's the biggest mistake investors can make.

• "In an April 10, 2000, article in BusinessWeek magazine, Jeffrey M. Applegate, chief investment strategist at Lehman Brothers, bluntly asked, "Is the stock market riskier today than it has been in the past two years simply because prices are higher? The answer is no."But the answer is yes. It always was. It always will be.And when Graham asked, "Will such foolishness go unpunished?" he knew the answer would always be no. Like some angry Greek god, the stock market destroyed anyone who was convinced that the high returns of the late 1990s were some sort of divine right. Just look at how the predictions of Ladis, Frolick, and Afflgate fell flat.

• From 2000 to 2002, Nokia, one of the ladies' most favourite or more stable wireless stocks, fell by 'only' 67% while Finstar Communications was even worse, down 99.9%.

• Owner preferred shares of Cisco Systems and Motorola fell by more than $200 at the end of 2003. Investors lost $5.4 trillion in Cisco alone, which is more than the combined bullish economic output of Hong Kong, Israel, Kuwait, and Singapore.In April 2000, when Peppleton first asked that question, the S&P Industrials was at 11,187. The Nasdaq Composite Index was at 4,446. By the end of 2002, the Bau was teetering around 8,300, while the Nasdaq was languishing at 1,300 on the brink of a massive tax crisis, having lost all of the previous year's profits.

the heaviest Remains there is a serious flaw in the argument that stocks have 'always' outperformed bonds over long periods of time. Reliable data is not available before 1871. The oldest index representing the US stock market returns only includes seven stocks (Shi Ho, 71). However, by 1800 there were about 300 companies in the US (including companies like the Jefferson-influenced Budden Turnpikes and Cavalry). Most of these went bankrupt, leaving investors to go bankrupt.But in those early years the stock indexes ignored all these companies that went bust. There was a problem, technically known as 'survivorship bias.' So these indexes overstated the earnings results of real investors who completely lacked the 20/20 hindsight needed to know which of the seven stocks to buy. These mutt companies included the Bank of New York and J.P. Morgan Chase. They had been prospering steadily since 1790, but for every one miraculous survival there were thousands more financial disasters, such as the Dismal Swamp Canal Company, the Pennsylvania Cultivation of Vines Company and the Snickers Gap Turnpike Company. All the 'historic' stock disappeared from the indexes.Data by Jeremy Siegel shows that, after inflation, chevrons grew by 2% per year between 1802 and 1870, rising to 4.8% in the 19th century, and5.1% in cash. But Elroy Hyman and his colleagues at the London Business School estimate that stock returns were at least two percentage points higher per year before 1871. In the real world back then, stocks were not much better than cash or bonds, but only a few points. Anyone who claims that the long-term record 'proves' that stocks have outperformed bonds or cash is ignorant.By the 1840s, these indices had grown to include up to seven financial stocks and 16 railroad stocks. It is also a grossly unrepresentative sample of the market on the American stock exchange.*See article 'Jan and Jan' by Joran Chaig in Time magazine, May 6, 2002, page 711. Graham indicates that between 1921-1920, stock markets also suffered from the "sneaking bad luck". Hundreds of automobile, aviation and radio companies crashed without leaving a trace. These returns are probably overstated by one to two percentage points.

The higher the altitude, the steeper the fall As a permanent antidote to such bull market hypocrisy, Praham urges the intelligent investor to ask some simple and skeptical questions. Why will future stock results always be the same as past results? If all investors are convinced that stocks are guaranteed to make money in the long run, won't the market become wildly overpriced? And once that happens, how much room will future returns hold?Graham's answers, as always, are based on logic and common sense. The value of any investment, as it should be, is a result of the price you pay for it. In the late 1990s, inflation was falling, corporate profits were booming, and much of the world was at peace, but that doesn't and never will mean that stocks are worth buying at any price. If the profits of a growing company are limited, then the price an investor is willing to pay for a stock should be limited as well.Think of it this way: Michael Jordan may be the best basketball player of all time, and he draws fans to Chicago Stadium like a giant magnet. The Chicago Bulls paid $534 million to make a big leather ball skip across a hardwood floor, but that doesn't mean the Bulls could justify paying him $340 million, or $3.4 billion, or $34 billion per season.

limits of Optimism

graham warns that while recent market returns may be impressive, it can be 'very irrational and dangerous' to focus on them and conclude that ordinary stocks can be expected to produce equally spectacular results in the future. Stock buyers became even more optimistic from 1995 to 1999, when the market rose at least 20% per year - a gain never before seen in US history.

• In mid-1998, investors surveyed by the Gall up Organization for the Paine Webb brokerage firm expected their portfolios to earn roughly 13% on average in the coming year. By early 2000, their average returns were expected to jump to more than 16%.
• The 'smart professionals' also behaved in a bullish manner, raising their estimates on future returns. For example, in 2001, SBC Communications.

raised the expected return on its pension plans from 8.5% to 9.5%. By 2002, the average expected rate of return for pension plans of companies in the Standard & Poor's 500 stock index rose to a record high of 9.2%.The quick follow-up shows the dire consequences of excessive enthusiasm.

• Gallup found that between 2001 and 2002, the average expected one-year return on stocks had fallen to 7%, while investors could now buy at roughly 50% lower prices than in 2002.'

• According to recent Wall Street estimates, S&P 500 companies that made optimistic estimates about returns on their pension plans cost them $32 billion between 2002 and 2004.

Although all investors know they should buy low and sell high, they are actually doing the opposite. In this chapter, Graham warns emphatically: According to the law of opposites, the more bullish investors are about the stock market over the long term, the more certain they are to be proven wrong in the short term. On March 24, 2000, the total value of the U.S. stock market peaked at $14.75 trillion. By October 9, 2002, just eight months later, the total value of the U.S. stock market had fallen to $7.34 trillion, a loss of 50.2% to $7.41 trillion. Meanwhile, many market analysts had become very bearish and predicted flat or negative market returns not just for years to come, but for up to a decade.At this point Graham might ask a simple question: the last time these "experts" agreed on something, they were proven disastrously wrong. So why should the intelligent investor believe them now?

What next?

Instead, let's cut through the noise and look at future returns the way Graham did. The performance of the stock market depends on three factors:

• Real growth (growth in company's earnings and dividends)
• Inflation (general price increases across the economy)
• Speculative rise or fall (increase or decrease in people's interest in stocks).

Over the long term, corporate earnings per share growth has averaged 1.5% to 29% annually (not counting inflation). In early 2003, inflation was about 2.4% annually, the dividend yield on stocks was 1.9%, so,

1.5% in 2%

 +2.4%

+1.9% 

5.8% in 6.3%

This means you can expect stocks to return about 6% on average (or 2% after inflation) over the long term. If the investing public gets greedy again and puts the stocks back into the market, that speculative window could lead to temporarily higher returns. In turn, if investors get fearful, as they were in the 1930s and 1970s, stock returns could be temporarily lower (as we had in 2013).Robert Shiller, a finance professor at Yale University, says that the stock market inspired his valuation approach. Shiller compares the current price of the Standard & Poor's 500-stock index to the average corporate profit (after inflation) over the past 10 years. Examining the historical record, Shiller shows that when the ratio rises above 20, the market typically produces poor returns. When it falls below 10, stocks often produce the best returns. According to Shiller's math, in early 2003, the stock price  The average over the past decade was about 22.8 times inflation-adjusted income -- still within danger zone, but well below the precarious level of 44.2 times income in December 1999.How did the market perform the last time it was at today's level? Figure 3-1 shows the last period when stock prices were as high as today, and the next 10-year period of time. 

So, at the same price level as in early 2003, the stock market has done quite well, at times poorly, and at other times patchy in the following 10 years. I think Graham, being conservative, would have divided the difference between the lowest and highest returns of the past and used that as a parameter to estimate the next decade's stock yield to be roughly 6% annually, or 4% after inflation. (Interestingly, this estimate is similar to the estimate we arrived at by combining real growth, inflation growth, and speculative growth.) 6% is a drop in the bucket compared to the 1990s, but that modest amount is better than the returns that bonds are likely to provide, and that's why most investors maintain a portion of stocks for portfolio diversification.But there is another lesson in Graham's method. The only thing you can say with certainty in predicting future stock returns is that you will probably be wrong. The past teaches us one undeniable truth: the future always surprises. And the law of natural consequences from financial history is that the market is most likely to surprise those who believe their predictions are correct. Like Graham, being modest about your predictive power will help you avoid taking too big a risk on the future that turns out to be wrong.So, no matter what, you have to keep your expectations low. But be careful not to let your spirits be disappointed. In The Intelligent Investor, hope must always be strong, because it is there. In the financial markets, the worse the future looks, the better it often turns out to be. A skeptic said to the Whitish novelist and essayist G.K. Chesterton, "Blessed is he who has no hope, for he will never be disappointed." Chesterton replied, "Blessed is he who has no hope, for he will enjoy everything."