But when stocks start racing upward and everyone’s getting giddy on the profits they’re making, most people ignore their bonds (if they own any at all) and they buy more stocks. Many others chase whichever fund has recently done well.
How can you ensure that you’re never a victim? It’s far easier than you might think. If you understand exactly what stocks are—and what you can expect from them—you’ll fortify your odds of success.
On Stocks . . . What You Really Should Have Learned in School
The stock market is a collection of businesses. It isn’t just a squiggly bunch of lines on a chart or quotes in the newspaper. When you own shares in a stock market index fund, you own something that’s as real as the land you’re standing on. You become an indirect owner of all kinds of industries and businesses via the companies you own within your index: land, buildings, brand names, machinery, transportation systems, and products, to name a few. Just understanding this key concept can give you a huge advantage as an investor.
Business earnings and stock price growth are two separate things. But long term, they tend to reflect the same result. For example, if a business grew its profits by 1,000 percent over a 30-year period, we could expect the stock price of that business to appreciate similarly over the same period.
It’s the same for a stock market index. If the average company within an index grew by 1,000 percent over 30 years (that’s 8.32 percent annually) we could expect the stock market index to perform similarly. Long term, stock markets predictably reflect the fortunes of the businesses within them. But over shorter periods, the stock market can be as irrational as a crazy dog on a leash. And it’s the crazy dog’s movements that can—if we let them—lure us closer to poverty than to wealth.
True Stock Market Experts Understand Dogs on Leashes
I used to have a dog named Sue. She behaved as if we were feeding her rocket fuel instead of dog food. If you turned your back on her in the backyard, she’d enact a scene from the US television show Prison Break, bounding over the 5-foot-high fence in our yard and straining diplomatic relations between our family and those whose gardens she would destroy.
When I took her for extended runs on wide, open fields, she burned off some octane. I would run in a single direction while she darted upward, backward, right, then left. But collared by a very long rope, she couldn’t escape.
If I ran from the lake to the barn with Sue on a leash, and if it took me 10 minutes to get there, then any observer would realize it would take the dog 10 minutes to get there as well. True, the dog could bolt ahead or lag behind while sticking its nose in a gift left behind by another canine. But ultimately, it can’t cover the distance much slower or much faster than I do—because of the leash.
Now imagine a bunch of emotional gamblers who watch and bet money on leashed dogs. When a dog bursts ahead of its owner, the gamblers put money on the sprinting dog, betting that it will sprint far off into the distance. But the dog’s on a leash, so it can’t get too far ahead of its owner. When the leashed dog gets ahead, it’s destined to either slow down or stop—so that the owner can catch up.
But the gamblers don’t think about that. If they see the dog bounding along without noticing the leash, they place presumptuous bets that the dog will maintain its frenetic pace. Their greed wraps itself around their brains and squeezes. Without that cranial compression, they would see that the leashed dog couldn’t outpace its owner.
It sounds so obvious, doesn’t it? Now get this: the stock market is exactly like a dog on a leash. If the stock market races at twice the pace of business earnings for a few years, then it has to either wait for business earnings to catch up, or it will get choke-chained back in a hurry. But a rapidly rising stock market can cause people to forget that reality. I’ll use an individual stock to prove the point.
Coca-Cola Bounds from Its Owner
From 1988 to 1998, the Coca-Cola Company increased its profits as a business by 294 percent. During this short period (and yes, 10 years is a stock market blip) Coca-Cola’s stock price increased by 966 percent. Because it was rising rapidly, investors (including mutual fund managers) fell over themselves to buy Coca-Cola shares. That pushed the share price even higher. Greed might be the greatest hallucinogenic known to man.
The dog (Coca-Cola’s stock price) was racing ahead of its master (Coca-Cola’s business earnings). A rational share price increase must fall in line with profits. If Coca-Cola’s business earnings increased by 294 percent from 1988 to 1998, we would assume that its stock price would grow by a percentage that was at least somewhat similar, maybe a little higher or maybe a little lower. But Coca-Cola’s stock price growth of 966 percent was irrational, compared with its business earnings increase of 294 percent.10
Figure 4.2 Coca-Cola’s Stock Price vs. Coca-Cola’s Earnings
Source: Value Line Investment Survey
Can you see what happened to the blazing Coca-Cola share price when it got far ahead of Coca-Cola’s business profits?
The dog eventually dropped back to meet its owner. After blazing ahead at 29 percent a year for a decade (from 1988 to 1998), Coca-Cola’s stock price eventually “heeled.” It had to. You can see in Figure 4.2 that the stock price was lower in 2011 than it was in 1998.
Coca-Cola’s earnings growth and stock price were realigned, much like a leashed dog with its owner.
You can look at the earnings growth of any stock you choose. Over a long period, the stock’s price might jump around, but it will never disconnect itself from the business earnings. To see a few examples for yourself, you can log on to The Value Line Investment Survey. The US research company offers free, online historical data of the 30 Dow Jones Industrial stocks.
The Madness of People
Coca-Cola wasn’t the only business with a share price that was out of step with its business earnings. Stock market investors worldwide euphorically flocked to stocks in the late 1990s, as they were motivated by rising prices. The stock buying grew more frenzied during the latter part of the decade as stock prices reached lofty new heights. The United States (for example) went through a period of strong economic growth during the 1990s. But the prices of stocks were rising twice as fast as the level of business earnings. It couldn’t last forever, however. The decade that followed saw the racing, leashed dogs eventually fall in line with their owners who were moving at a much slower rate.
Global stock markets also took a breather between the year 2000 and 2010. They rose just 21 percent for the decade, after climbing 250 percent between 1989 and 1999, as measured by the MSCI index of developed country stock markets.11
Stocks Go Crazy Every Generation
Long term, whether we’re talking about Coca-Cola or a stock market index, there’s one reality: the growth of stock market prices will closely match the growth of the businesses they represent. It’s supply and demand that pushes stock prices over the short term. If there are more buyers than sellers, the stock price (or the stock market index in general) will rise. If there are more sellers than buyers, stocks will drop. And when prices rise, people feel more confident about that investment. They buy more, pushing the price even higher. People become drunk on their own greed, not recognizing that bubbles form when price levels dramatically exceed business profit growth.
“History Doesn’t Repeat Itself, But It Does Rhyme”—Mark Twain12
As far back as we have records, at least once every generation, the stock market goes bonkers. Table 4.4 presents three periods from the past 90 years showing the US market as represented by the Dow Jones Industrial stocks. You can see, in each case, share price levels that grossly exceeded earnings levels, and the terrible returns that followed as the “dogs” were caught by their “owners.”
Table 4.4 Prices of Stocks Can’t Outpace Business Earnings for Long
Years When Stock Prices Exceeded Business Earnings Growth in Business Earnings (the Pace of the Dog’s Owner)
Growth in Stock Prices (the Pace of the Dog)
> Stock Price Decline/Gain (the Dog’s Overall Progress) During the Following Decade
1920–1929 118%
271.2%
-40.9%
1955–1965 150%
198.5%
29.3%
1990–2000 152%
290%
20.17%
Note: Figures do not include dividends.
Source: The Value Line Investment Survey13
Note from 1920 to 1929, the Dow stocks’ average business growth amounted to 118 percent over the 10-year period. But the prices of the Dow stocks increased by 271.2 percent over that decade, so if someone invested in all 30 Dow stocks in 1920 and held them until 1929, he would have gained more than 271 percent not including dividends and close to 300 percent including dividends. Because stock prices can’t exceed business growth for long, the decade that followed (1930–1940) saw the stock market fall by an overall total of 40.9 percent. Again, the leashed dog can’t escape its owner.
The two other time periods during the past 90 years where investors lost sight of the connections between business earnings and stock price appreciation occurred from 1955 to 1965 and from 1990 to 2000. You can see the results in Table 4.4
Anyone investing in a broad US stock market index would have gained more than 300 percent (including dividends) in the 10 short years between 1990 and 2000. Did business earnings increase by 300 percent? Not even close. That’s the main reason the markets stalled from 2000 to 2010.
How Does this Relate to You?
Every generation, it happens again. Stock prices go haywire. When they do, many people abandon responsible investment strategies. The more rapidly the markets rise, the more reckless most investors become. They pile more and more money into stocks, ignoring their bonds. And when the markets eventually fall or stagnate, they curse their bad luck. But luck has little to do with it.
Internet Madness and the Damage It Caused
The greatest Titanic period of delusion sailed during the technology stock mania of the late 1990s. The stocks that were riskiest were those companies with the greatest disconnection between their business earnings and their stock prices.
Many Internet-based businesses weren’t even making profits but their stock prices were soaring, pushed upward by the media and the scintillating stories of Silicon Valley’s super-rich. Most of their investors probably didn’t know that there’s a direct long-term connection between stock prices and business earnings. They probably didn’t know that it’s not realistic for businesses to grow their earnings by 150 percent a year—year after year, no matter what the business is. And if businesses can’t grow earnings by 150 percent on an annual basis, then their stocks can’t either.
Some of the more famous promoters at the time were such high-profile financial analysts as Morgan Stanley’s Mary Meeker, Merrill Lynch’s Henry Blodgett, and Solomon Smith Barney’s Jack Grubman. But they might have a tough time showing their faces today. For all I know, the top Internet stock analysts of the 1990s are now hiding in an African jungle, hoping that angry investors won’t find them. Their voices tossed buckets of gas on the flames of madness when technology-based companies without profits were priced in the stratosphere. Meeker, Blodgett, and Grubman were encouraging the average person to buy, buy, buy.
One difference between this period and the bubbles of previous generations was the speed at which the bubble grew, thanks to the Internet as a rapid communication channel. One transgenerational similarity, however, was the investors’ attitude that “this time it would be different.” In each period where stock prices disconnect from earnings levels, you find people who think that history is going to rewrite itself, that stock prices no longer need to reflect earnings, and that leashed dogs everywhere can develop mutations, grow wings, and lead flocks of Canadian geese on their way to Florida. In the long term, stock prices reflect business earnings. When they don’t, it spells trouble.
Table 4.5 How Investors Were Punished
Formerly Hot Stocks $10,000 Invested at the Market High in 2000
Value of the Same $10,000 at the Low of 2001–2002
Amazon.com $10,000
$700
Cisco Systems $10,000
$990
Corning Inc. $10,000
$100
JDS Uniphase $10,000
$50
Lucent Technologies $10,000
$70
Nortel Networks $10,000
$30
Priceline.com $10,000
$60
Yahoo! $10,000
$360
Source: Morningstar and Burton Malkiel, A Random Walk Down Wall Street, 200314
Even shares of the world’s largest technology companies sold at nosebleed prices as they defied business profit levels. And, as shown in Table 4.5, when cold, hard business earnings eventually yanked the price leashes back to Earth, people who had ignored the age-old premise (that business growth and stock growth is directly proportional) eventually lost their shirts. Investing $10,000 in a few of the new millennium’s most popular stocks during 2000 would have resulted in some devastating losses for investors.
The stories of wealth enticed individual investors and fund management firms alike before the eventual collapse of the dot-com bubble.
Mutual fund companies rushed to create technology-based funds that they could sell. The job of fund companies, of course, isn’t to make money for you or me. Their primary job is to make money for their companies’ owners or share-holders.
There’s a saying that “Wall Street will sell what Wall Street can sell.” In this case, newly introduced technology-stock mutual funds were first-class tickets on airplanes with near-empty fuel tanks. Passengers giggled with delight as they soared into the clouds . . . until the fuel ran out.
Sadly, there were plenty of regular middle-class folk who climbed aboard this soon-to-be-plunging craft. When the plane hurtled into the ground, many investors in technology funds and Internet stocks lost nearly everything they had invested.
Few players in the Internet stock fiasco escaped unscathed. You might imagine loads of people getting out on top, or near the top, but the hysterical era of easily quadrupling your money within a matter of months swept through amateur and professional investors alike. Nobody really knew where that “top” was going to be, so loads of people kept climbing into tech stocks.
I’d be lying if I claimed to avoid the tech sector’s sirens. In 1999, I succumbed to buying shares in one of the technology stock darlings of the day, Nortel Networks.
It was silly of me to buy it, but watching my friends making bucket loads of easy money on Internet stocks while I sat on the sidelines was more than I could take. Swept up in the madness, it didn’t matter that I didn’t really know what the company did.
Eventually getting around to reading Nortel’s annual report, I recognized that the company had been losing more and more money since 1996. But I didn’t care. Sure, it made me nervous, but the stock price was rising and I didn’t want to be left behind.
What was worse was that every year since 1996, the business was losing more and more money while its stock price was going in the opposite direction: up! I paid $83 a share. When that stock price rose to $118, I had made a 42 percent profit. Late getting onto the Nortel train, I couldn’t believe the money I had made in such a short time. Recognizing a quick profit, I figured it would be wise to sell, which is exactly what I did at $118 a share. If only the story ended there. No sooner did I sell than the price rose to $124 a share.
Then I read an analyst’s report suggesting that the share price was going to rise to $150 before the year was up. What was I doing, selling at $118?
Shortly after the stock price dipped to $120, and like a knucklehead, I bought back the shares I had previously sold. I was watching the dog while ignoring the owner’s rigor mortis.
And that’s when gravity hurtled the stock price down to $100 a share . . . then $80 a share . . . then $50 a share. Suddenly, people noticed the
smell.
I sold at $48, losing almost half of what I put into my investment. I got burned for buying a stock I never should have bought in the first place because—despite the meteoric rise in its stock price—the business itself hadn’t made a dime in years.
But I was lucky. Today, those same shares are worthless.
Many of my friends never sold. It’s a shameful reminder of what can happen when we mix greed and ignorance.
Taking Advantage of Fear and Greed
Buying a total stock market index fund needn’t be boring. If you can be greedy when others are fearful and fearful when others are greedy, you can add a touch of nitrate to your investment portfolio. You don’t need to follow investment news or follow the markets. You just need to utilize the safest component of your investment portfolio—your bonds.
The disastrous events of September 11, 2001, invoked tremendous fear in the American people when terrorists hijacked two airliners and flew them into New York’s World Trade Center. After the twin towers collapsed, the stock markets were temporarily closed. Sadly, nearly 3,000 people were killed in the terrorist attack.
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