Mean Markets and Lizard Brains Page 21

  Even If You Do Not Buy Any Stocks, You Own a Lot of Stock

  The final chapter of this book contains a summary of my recommendations for investing. For most people, my suggestion for stock investing will be lower than that advocated by Wall Street. Imagine for a moment that you follow my advice, or decide for other reasons to invest a modest amount in stocks. Now fast-forward 30 years to learn that stocks have done fantastically over that time. In 2035 you are looking back at your current financing decisions.

  Many investors that I know have fantasies of having made huge bets at just the right moment. One of my friends correctly predicted the surge in biotech stocks in the late 1990s. He made some money on his investments, but missed much of the opportunity (some of the stocks he followed went from $5 to over $100 in a year). Almost every conversation with him includes discussing his fantasy of borrowing every dime possible and buying those biotech stocks for the entire ride. Many other investors speak of similar dreams—betting against stocks during the bubble days, buying after the terrorist attacks in 2001, and more.

  Imagine our prudent stock investor who looks back on 30 years of stock market gains. The fantasy will be that she or he had invested every penny in stocks and made a ton of money. Even better, if time travel is invented, perhaps our investor in 2035 can travel back in time and change the investments. Wouldn’t it be great to look in your retirement account some years from now to find that magically your financial decisions had been altered so that you had made the perfect set of decisions?

  In Back to the Future, Marty McFly also wishes that he could change the world. Near the beginning of the film, he sees his mentor, the crazy professor, shot down by terrorists. Wouldn’t it be great if he could go back in time and change events so that the professor is prepared for the attack? That is exactly what McFly does by warning the professor when he is time traveling. Armed with this knowledge, the professor still gets shot, but a bulletproof vest protects him.

  So if U.S. stocks continue their 200-year run, we’ll wish we could go back in time to adjust our financial decisions accordingly. The funny thing is that when it comes to stocks, even if you don’t buy any stocks, you will most likely participate in any continued stock market rally. I’ve been making this point to my buddy Doug for years.

  Doug was a college roommate who now runs a number of entrepreneurial businesses in Southern California (and has become quite a surfer). He made a ton of money during the bubble years, in part by a huge investment in Qualcomm. At one point during those euphoric days Doug owned 8,000 shares of Qualcomm. He went out surfing one day and came back to learn that during his two-hour surfing trip, the stock had surged by over $70 a share. So in a morning of surfing, Doug’s investment in one stock increased by over half a million dollars! Not bad.

  Even after the bubble broke, Doug was still ahead on his stock purchases. During 2001 and early 2002, I constantly urged him to trim his stock holdings. “Do you think that stocks are going to decline further?” Doug asked. I responded by saying that my advice was not based on a prediction of the stock market. Frustrated, Doug said, “Why should I sell stocks if they are going to go up?”

  I had Doug then draw up a list of his assets. He was a rich guy worth millions. This money was divided between California real estate, the value of his businesses, and his stock holdings. I then asked him to describe a scenario in which his businesses were in trouble. The answer was that his businesses would suffer serious decline in a recession. The final question was to ask Doug about the value of his stock and his real estate in this scenario. The answer was that if the economic conditions went south, all three of his major sources of wealth would decline together.

  The conclusion was that even if Doug owned no stocks, his wealth would go up along with a stock market rise. Doug participates in any stock market boom even if he owns no stocks. His real estate and his businesses are worth more in the good economic times that foster stock market gains.

  Similarly, most of us effectively own stocks even if we haven’t bought any. Most importantly, our job prospects probably go up and down with the stock market. If we put most of our financial eggs into stocks, then precisely when we might need those resources because of problems in our lives, they are likely to be less valuable.

  Most of us need not fear missing a stock market rally. If events turn out rosy, when we look back from the perspective of 2035, it will be as if we had stuffed our portfolios full of stocks. In a stock market boom, we are likely to enjoy high salaries and rising real estate values. If things turn out less perfectly, we will likely need the money that we have and be glad if it isn’t all invested in risky stocks.

  Our Love Affair with the Stock Market Continues

  Stocks seem to be close to fairly valued. It is easy to construct scenarios that make stocks look cheap and similarly easy to imagine worlds where they are expensive. This balancing of risk and reward is the definition of fair value.

  My worries about investing in U.S. stocks come not from such fundamental analysis but rather from a perspective on emotional cycles. When financial manias reach the magnitude that we saw in the late 1990s, the recovery generally requires a period of extreme pessimism. While we had a significant bear market after the bubble burst, it seems that we never reached the requisite depths.

  The final piece of evidence in this argument is that almost no one believes it. In fact, I find it hard to believe myself. I began serious stock purchases in the early 1980s. You could buy fantastic, rapid-growth companies with single-digit PEs. I used to walk around my San Diego apartment hitting the Wall Street Journal with excitement and muttering to myself, “It is a historic time to buy stocks.” I knew that stocks were cheap.

  Throughout my investing life, stocks have been the best investment. So much so that I have earned far more from stocks than from wages. All of my training suggests that stocks cannot be as good an investment now as they have been throughout my life. Nevertheless, I don’t really believe it. Or more precisely, my backward-looking lizard brain simply can’t get over the fact that stocks have made me a lot of money.

  For those of us who have made money for decades by plowing money into stocks, it is extremely tough to kick the habit. The argument against being completely bullish on U.S. stocks is an argument of cognition against experience. My lizard brain still tells me to invest everything in stocks even though my analyses suggest otherwise. With my rational side, I am able to control my investments, but I can’t stop my lizard brain from loving stocks.

  Love affairs, whether of the wallet or the heart, share common elements. In Shakespeare in Love, the young playwright falls in love with cross-dressing Viola de Lesseps (played by Gwyneth Paltrow in her Academy-Award-winning role). Along their romantic road to an eventual happy ending, Shakespeare and his love must endure a set of challenges, including a very public engagement between Viola and Phillip Henslowe (played by Geoffrey Rush).

  Because Viola’s fiancé is a lord, the whole gang ends up before Queen Elizabeth. Another lord in the audience asks the queen how the story will end. She replies, “As stories must when love’s denied: with tears and a journey.”

  While we have had some tears in our love affair with stocks, Figure 8.8 shows that there has been no journey away from stocks. Over the 10 years spanning 1994 to 2003, investors have placed an additional $1.5 trillion in long-term equity mutual funds. In the post-bubble world, the rhetoric surrounding stocks is somewhat tempered but there has been no movement away from stocks as an investment class. Before stocks represent outstanding value, I predict there will be many years during which investors are taking money out of stocks.

  It is the 1998 edition of Professor Siegel’s Stocks for the Long Run, that proclaims, “Stocks are actually safer than bank deposits!” Of course, two years after this edition was published, the S&P 500 lost half its value, and the NASDAQ lost 70% of its value. In the post-bubble, 2002 edition of Stocks for the Long Run, the dust-jacket promotion of stocks being safer than bank depos
its has been removed. Nevertheless, the message remains the same. In fact, Professor Siegel’s advice on investment allocation is worded identically in both pre- and post-bubble editions, “Stocks should constitute the overwhelming proportion of all long-term financial portfolios.”19

  FIGURE 8.8 America’s Love Affair with Stocks Is Not Over

  Source: Investment Company Institute, 2004 Fact Book, Table 13

  Stocks for the long run is still the conventional wisdom. In their 2004 retirement planner, The Motley Fool website says, “Fools opt for stocks above all else as our vehicle of choice for growth over the long term.” (Devotees of the Motley Fool call themselves “fools” as a compliment.)

  We’ve seen that Wall Street still recommends that about two-thirds of all investments should be in stocks. Furthermore, Americans own historically high levels of stocks. In a Shakespearean sense, we’ve had the tears of a bear market, but we have not had the voyage away from stocks that generally marks the end of an investment era.

  U.S. stocks are still the most loved of all investments. If the most loved investment proves to be the most profitable, it will be the first time in investing history. I conclude, in answer to Peter Borish’s question, that buying stocks is indeed driving the financial car by looking in the rearview mirror.

  I still recommend a significant investment in stocks, not because I expect them to have higher returns than all other investments, but because stocks have tax advantages and generally unrecognized advantages as risk reducers. While I advocate a substantial investment in stocks, I am far more sanguine about their prospects than Professor Siegel or Wall Street.

  FIGURE 8.9 U.S. Stock Market Returns Have Disappointed

  Sources: Robert Barro, Quarterly Journal of Economics 3, 2006; Dow Jones

  Update since the First Edition

  Recent U.S. stock market returns have been disappointing. From 1880 to 2005, the average return after inflation was 8.0% per year. In sharp contrast, the returns beginning in January 2005 have been 1.8% per year (Figure 8.9).

  What’s Next?

  As always, there are two ways to look at stock valuations. Using standard macroeconomic and financial analysis, U.S. stocks look to be fairly valued. The average price-to-earnings ratio, for example, is not at any historic extremes. This rational perspective suggests that U.S. stocks are nothing to get excited about, nor anything to fear.

  The lizard brain view of U.S. stocks, however, remains stuck on disappointing for exactly the same reasons as noted in the first edition. Stocks are still the favored investment class, and there has been no wholesale movement away from U.S. equities. As long as U.S. stocks remain loved, they are unlikely to have high returns by historical standards. U.S. equity markets are therefore likely to remain mean.

  chapter nine

  REAL ESTATE Live in Your Home; Make Your Money at Work

  Can We Continue to Make Lots of Money on Our Homes?

  In the late 1980s my friends Peter and Julie paid more than $1 million for an apartment on Manhattan’s Central Park West. Their beautiful 4,000+-square-foot residence is in a prestigious building and has a view of Central Park.

  Peter bought the property even though he held negative views on the economy. Accordingly, I asked, “If you think the economy is in trouble, doesn’t that mean that housing prices will fall? Doesn’t your doom and gloom view mean that you will lose money on your home?”

  “Make your money at work and live in your home.” That was Peter’s response to my query. He explained that he expected to continue to make good money at work, and that he didn’t really care what happened to real estate prices. He intended to live in his apartment indefinitely, thus the ups and downs in valuation were irrelevant.

  Peter’s “don’t expect to make money on real estate” philosophy seemed reasonable for three reasons.

  First, housing appreciation will have its ups and downs. For every buyer of a house, there must be a seller. Unless sellers are idiots, they should sell only if the price is fair. Since housing prices sometimes go up a lot, “fair” requires that housing prices should sometimes go down. Houses are risky investments and should not be expected to increase continuously. There should be bear markets in houses. This is predicted by both the rational (efficient markets hypothesis) and irrational views of markets.

  Second, throughout most of history land and home prices have, in fact, gone up and down. The most obvious U.S. example of a real estate bust is the dustbowl of the 1930s. But it does not take a depression to hurt land prices. From 1992 through 2004, for example, Japanese land prices fell every year and lost almost half their value.1 This severe decline took place even though Japan remains one of the richest countries in the world and did not suffer an economic depression.

  Third, the theory of comparative advantage—one of the most important theories in economics—suggests that most people should make their money at work and not in real estate. According to an oft-told story, Professor Paul Samuelson, winner of the 1970 Nobel Prize in Economics, was once asked by a physicist to name one idea in economics that is true and nontrivial. Without hesitation, Professor Samuelson answered “comparative advantage.” What is this theory, and why does it validate Peter’s cautious view of real estate prices?

  Comparative advantage, first articulated by David Ricardo in the nineteenth century, suggests that we (both as a country and as individuals) can make the most money by focusing on what we do best.2 In his famous economics textbook, Professor Greg Mankiw (whom we have met before and will again in a minute) asks whether Tiger Woods should mow his own lawn.3 The theory of comparative advantage says that even if Tiger Woods has an absolute advantage—meaning that he is better than all others—in lawn cutting, he should spend his time with a golf club in his hands and not grass clippers.

  My favorite example of a failure to understand comparative advantage comes from a 1979 article written by James Fallows about President Jimmy Carter. Mr. Fallows worked at the White House and would ask for time on the private tennis courts through President Carter’s secretary. Mr. Fallows claims that President Carter himself would schedule the White House tennis courts. On his request for court time Fallows writes, “I always provided spaces where he [President Carter] could check Yes or No; Carter would make his decision and send the note back, initialed J.”4 (President Carter has denied this.)

  Comparative advantage and common sense suggest that even though President Carter was in a unique position to schedule the courts, his time would have been better spent elsewhere.

  What does comparative advantage have to do with real estate prices? Most people are not experts in real estate, but are experts at something else—often the work they do for a living. Is it more likely that you will make money by doing what you have trained for all your life, or in something you spend a few hours on a year?

  The answer seems as clear as the fact that Tiger Woods should not mow his own lawn and Jimmy Carter should not schedule tennis courts. Those of us who are not real estate specialists should expect to make our money in the area where we are experts—at work. This provides the connection between Peter’s enigmatic comment and economic theory. We should expect to make our money where we have a comparative advantage (in our jobs) and not where we are comparative neophytes (in our home purchases).

  So how did Peter do in his work and with his real estate investment? His outcome was exactly the opposite of that predicted by the theory of comparative advantage. Peter has done fine at work, but even better in his home. Peter’s real estate investment has soared in value and has increased his net worth by millions of dollars. So Peter actually lived in his home and made his money in his home!

  Both economic theory and historical experience suggest that Peter was right to seek shelter in his home and profits in his paycheck. His actual outcome—making more money in real estate than in income—is similar to that of many Americans.

  In fact, Americans have come to rely on the housing market for financial gain. While the stock m
arket has gone nowhere for almost half a decade, housing prices have steadily increased. Accordingly, U.S. real estate values are at all-time highs both in pure dollar terms and also as a percentage of our wealth.5

  Can we continue to both live in and profit from our homes? Can we continue to make our money where we don’t have a comparative advantage? Alternatively, is it likely that home prices will stabilize or even decline?

  The Harvard Economist versus the Gutsy Immigrant

  With the 2005 version of King Kong (starring Jack Black, but not as the monster) coming to theaters, can it be long before we have more super monster battles on the big screen? In 1962 King Kong fought Godzilla, who in turn has fought many other beasts. Perhaps the most surprising was the defeat of Godzilla by the caterpillar children of Mothra (“Mosura” in the original Japanese).

  When it comes to housing prices, there was an interesting—albeit unknown—superbattle that took place in Massachusetts back in the late 1980s. On the one side stood world-famous Harvard economics professor Greg Mankiw. In opposition was Fatima Melo, a Portuguese immigrant with no college education. In the battle to predict housing prices whom would you bet on?