by Maggie Mahar
Yet when investing their life savings, those who have been trained by a long bull market tend to focus on the frequency rather than the size of the risk. “Investors pay too much attention to what happens ‘on average,’” said Taleb. “Investing in equities is often a successful strategy, but it does not matter how frequently a strategy succeeds if failure is too costly to bear.” In other words, an investor must always ask himself: What is the worst thing that can happen—and can I stand it?32
This is why a 55-year-old investor with a nest egg of $250,000 “would be crazy to put 80 percent of his money into the stock market,” Peter Bernstein declared in 2002. Even if the odds are high that over the next 10 years he will make money, “if he’s wrong, he is dead.” There is always the possibility, however slim, “that bears like Bob Prechter could be right,” said Bernstein, referring to Robert Prechter’s 2002 prediction that the Dow could fall below 1000. “No one knows.”33
The most dangerous error investors make, Bernstein and Taleb agreed, is “to mistake probability for certainty.” By concentrating on what is most probable, or what happens “on average,” investors often ignore the worst-case scenarios. For precisely this reason, said Taleb, investing can be more treacherous than a game of Russian roulette. “Reality is far more vicious…. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security.
“Second, unlike a well-defined precise game like Russian roulette where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. One is thus capable of unwittingly playing Russian roulette—and calling it by some alternative ‘low risk’ name. We see the survivors and never the losers…. The game seems terribly easy and we play along blithely.”34 So, in the late nineties, investors buying stocks at 100 times earnings did not recognize the size of the risks they were taking. They called the game of picking stocks by an alternative, low-risk name: “investing in an efficient market.”
In fact, Taleb’s black swan could appear tomorrow. The stock that everyone said was a safe haven could blow up. Following a bear market rally, the Dow could suddenly drop 1000 points. “People tend to think of low-probability events as being distant in time,” said Bernstein. “In other words, we say, ‘Well, yes, gold went to $800 an ounce, but that was more than 20 years ago.’ Or, ‘Well, yes, in 1980 we had double-digit inflation—that couldn’t happen now.’” But he was emphatic: “Probability has nothing to do with time.” The surprise that would upset the best-laid forecasts could be waiting just around the corner. “When I explain this to people, they nod their heads,” he added, “but it is very difficult to get them to believe it, to act on it.”35
STRATEGIC MARKET TIMING
The trick, then, is not to try to time the bear market’s treacherous peaks and valleys (even though they might last a year, or longer), but to recognize the primary long-term trend—to recognize, in Richard Russell’s words, “whether the tide is coming in or going out.”
The Dow Theory that Russell used for nearly 50 years does not attempt to forecast the market’s short-term gyrations. As noted, it focuses on the underlying cycles. The strategy stood Russell in good stead. During the final two decades of the 20th century, readers who followed the advice in Richard Russell’s Dow Theory Letter earned, on average 11.9 percent a year, beating a buy-and-hold strategy, on a risk-adjusted basis, from June of 1980 to the end of 2001, according to Marc Hulbert, the editor of a newsletter that tracks financial newsletters. Russell’s record was particularly impressive given the fact that those two decades included a 17-year bull market—a time when a buy-and-hold strategy normally trumps market timing.36
Does Russell’s market timing work even better in a bear market? “The value of the strategy is more apparent in a bear market,” Hulbert allowed—then smiled. “But that’s like saying fire insurance works better when there is a fire.”37
Hulbert was right. Long-term market timing is designed to function like insurance—to protect an investor from the worst losses of a secular bear market. “In a bear market, everyone loses, but it is the people who lose the LEAST who are the winners,” Russell warned his readers in 2002.38
What Russell’s success suggests is that timing the long term can be far more fruitful than trying to predict the short term: “People ask what is going to happen next year, and I say I haven’t the faintest idea,” Jeremy Grantham admitted. “In general, the short term is unknowable and in an uncertain world, it should be unknowable.”
By 1997, Grantham, like Gail Dudack, knew that the financial frenzy would not end pleasantly, though he did not know when. “These things are predictable, but at uncertain horizons,” said Grantham, a perspicacious, if occasionally prickly, Englishman. In other words, he could predict the ending, but not the way there.
Some clients were unsatisfied. “How,” they asked, “is it possible to forecast the long run if you cannot predict the short run? After all, the long run is made up of a series of short runs.” This is a question that Grantham heard often, indeed more often than he wished to remember. (“Who knew you’d be giving the bear market speech for four years?” he grumped, referring to the amount of time it took for clients to admit that the bull market had indeed peaked and ended.) Still, he recognized, it was a very good question.
After two years of “constantly fighting with audiences and clients over this paradox,” he finally arrived at a satisfactory answer: feathers.
“Think of yourself standing on the corner of a high building in a hurricane with a bag of feathers,” said Grantham. “Throw the feathers in the air. You don’t know much about those feathers. You don’t know how high they will go. You don’t know how far they will go. Above all, you don’t know how long they will stay up. You know canaries in Jamaica end up in Maine once in a blue moon. They just get swept along for a week in a hurricane. Yet you know one thing with absolute certainty: eventually on some unknown flight path, at an unknown time, at an unknown location, the feathers will hit the ground, absolutely, guaranteed. There are situations where you absolutely know the outcome of a long-term interval, though you absolutely cannot know the short-term time periods in between. That is almost perfectly analogous to the stock market.”
Grantham recalled his clients’ response. “They would just say, ‘Oh,’ then grin, and shut up. It was such a revelation to me. If you can find the right analogy, suddenly people understand.”39
NEW THEMES
By 2003, market veterans such as Grantham, Peter Bernstein, Gail Dudack, Marc Faber, Richard Russell, Jim Grant, The Bank Credit Analyst’s Martin Barnes, Pimco’s Bill Gross, and Bob Farrell, Merrill’s longtime star market timer, all had begun to suggest that investors needed to rearrange their priorities. Those investing for the long term should look beyond the S&P 500, the Nasdaq, and the Dow. Over the first decade of the new century, specialized sectors might shine, but by and large, the risk implicit in investing in common stocks outweighed the likely reward. The game was no longer worth the candle.
In 2003, Treasuries were not an appealing alternative. They, too, had just enjoyed a long bull run. This meant that investors would need to jettison yet another piece of conventional wisdom: that the only alternative to stocks is bonds. Just as at the beginning of the seventies, new themes were emerging.
In each era, you have to ask, “Who are the richest people in the world?” Bob Farrell noted. “In the fifties, it was the Duponts, the industrialists. In the sixties it was Sam Walton—the growth was in consumer stocks. By the end of the seventies, it was the Arabs and their oil—in the eighties, the real estate tycoons, especially in the Far East. Then, in the nineties, you had the technology entrepreneurs. Now, something else is going to generate wealth. My theory is that the next wealth generator is going to come from China or Russia—and natural resources. Emerging marke
ts peaked in the early nineties,” Farrell added. “You had real wealth destruction in ’97—from that you can build another platform for wealth.”40
“Getting the right asset class is so much more critical as a protector or a driver of your returns than focusing on individual stocks,” added Jeremy Grantham. “Individuals make a big error by spending too much of their time worrying about the names, and too little thinking about how their portfolio is structured and whether they are diversified enough.”41
COMMODITIES
As a new century began, investors who wanted to diversify began looking at natural resources. They seemed ready for a long-term move. In the eighties and nineties, while U.S. stocks and bonds soared, what the financial world calls “commodities” (which includes precious metals such as gold and industrial metals such as platinum, as well as crude oil and lumber, food, and fiber) languished, reaching a nadir at the end of the 20th century. Most made their lows between 1998 and 2002, and by June of 2003 many observers believed that a new cycle was beginning. “Commodities are up 77 percent from the lows they made in 1998,” Marc Faber observed, “a remarkable rise considering that investors had been saying that commodities would never rise again!” And because they were rising from such depths, plenty of upside remained. (See chart “Commodities Near All-Time Low,” Appendix, page 466.)
The bear market in commodities that began in 1980 had started the way many bear markets do: overinvestment had led to excess capacity. “A decade of high real prices (and fat profit margins) during the 1970s encouraged a massive expansion in the supply of commodities on a global scale,” explained John Di Tomasso, founder of the Di Tomasso Group, a commodity trading advisor based in Victoria, British Columbia. “Then, from 1980 until 1993, prices came under constant pressure. A price recovery began in 1993 but it was snuffed out by the 1998 Asian financial crisis. As a result, commodity prices tumbled from what were still relatively low levels. For producers this turn of events was a catastrophe.
“By the end of the nineties, many commodity prices stood near 100-year lows in real terms, and well below cost of production. Commodity producers had a serious problem. The combination of low selling prices and a high cost structure caused by rising energy prices put pressure on producers to take action, especially the inefficient or poorly financed producers.”
When prices fall, “producers tend to respond in predictable ways,” Di Tomasso continued. “Mines are closed; exploration budgets are slashed; husbandry is neglected; herds are reduced; and crops are substituted. New production is discouraged. In a free market economy, production without profit cannot continue indefinitely. At some stage, prices must rise at least to the point where producers can earn a living. Otherwise, overall production of these raw materials will shrink, causing prices to ultimately rise, anyway—Adam Smith’s ‘invisible hand’ restoring equilibrium in the marketplace.”
By 2000, Di Tomasso believed that the tide must turn: “Viewed within a long-term perspective, if reversion to historical ‘norms’ is a reasonable expectation, then commodity prices, in aggregate, could double,” he predicted. It has happened before—from the 1932 low to the 1934 high, in the midst of deflation and the Great Depression, commodity prices, on average, rose by 100 percent. “The point is this—commodity prices can increase if the decline in demand is met with a proportionately larger decline in supply (for example, OPEC’s modest crude oil production cutbacks in 1999 were followed by a tripling of energy prices).”42
He was right: as a new century began, the commodity index began to climb. Meanwhile, as emerging markets matured, demand for energy, food, and the raw materials of an industrial society grew. “If the world grows as much as people expect, demand will continue to rise,” said Faber in the summer of 2003. “In Asia, I can imagine oil consumption doubling over the next 10 years. Already, scooters are beginning to replace bicycles. China is importing more copper and iron ore. And each year, Asians are eating better—wheat, corn, soybeans, coffee, cocoa, they should all benefit. Prices won’t go down, and the volume of food sold will go up.”43
“Meanwhile,” Faber argued, “the easy-money policies of the world’s central bankers will, in the long run, reinforce inflation in commodity prices. They keep on lowering rates, hoping to revive the economy. But they forget that you can have inflation and recession at the same time, as was the case in Latin America in the eighties.” Gail Dudack agreed. “You could have the worst of all worlds: inflation in necessities—food, energy, housing, medical care—and deflation in other areas, with global competition keeping the price of manufactured goods [and profit margins] low.”
Some investors favored spreading their risk by betting on a basket of commodities. In 2002, Pimco launched a fund that tracked an index of commodity futures contracts and was backed by Treasuries that protect against inflation (TIPS). This meant that an investor would benefit from any gains in commodity prices while also earning a T-bill rate on his underlying collateral. The fund was designed to “provide a hedge against inflation, particularly unexpected inflation,” Robert Greer, Pimco’s real return manager, explained. Equally important, the index fund allowed an individual to invest in energy, grains, metals, livestock, food, and fiber without trying to trade commodities futures himself. Finally, Greer suggested, “commodities could provide some protection from many geopolitical surprises that could adversely impact stocks and/or bonds.”44
In the nineties, many “natural resource” funds focused primarily on oil and natural gas. In the 21st century, both the supply/demand equation and global uncertainty made energy an attractive long-term investment theme. But to many who followed the financial world’s cycles, the entire spectrum of commodities offered an even better hedge. Four years before Pimco opened its commodities fund, Jim Rogers, who had co-founded the Quantum fund with George Soros, launched his own commodity index and a private fund based on it. By the spring of 2003, Rogers’s fund boasted a compound annual return of 14 percent. “I would much rather be in commodities than shares in the next few years,” said Rogers.45 At that point, it seemed likely that more funds might begin to follow the broad-based model, offering individual investors the opportunity to stake out a claim in the commodities market without betting all of their chips on oil and gas.
GOLD AND THE DOLLAR
Gold’s allure may be irrational, but for centuries the metal that John Maynard Keynes called “this barbarous relic” has had a nearly mystical hold on the human imagination. Perhaps it has something to do with the fact that gold’s value seems eternal. “Gold is the child of Zeus; neither moth nor rust devoureth it,” Pindar wrote in the fourth century B.C. Fittingly, gold dissolves only in cyanide.
Traditionally, gold has been viewed as a borderless currency. As recently as 1989, “the Soviet Union, on the brink of collapse, sold off or swapped virtually its entire gold reserve in an effort to sustain its credit,” Timothy Green observed in The World of Gold, a valuable study of the metal. “The unique advantage of gold is that it is no one else’s liability; the dollar, sterling, the deutschmark, and the yen are…Go to China, and see the crowds packing the gold shops that have sprung up in Beijing, Shanghai, and Guanghzou, turning their paper yuan, which has depreciated almost daily in the last year or two, into ornaments of pure gold,” he wrote in 1993.46
A decade later, Richard Russell, Marc Faber, Jim Grant, Jean-Marie Eveillard, The Bank Credit Analyst’s Martin Barnes, and David Tice, editor of Behind the Numbers, favored real assets—especially gold—as a hedge against the dollar. By 2003, gold already had begun its ascent: Jean-Marie Eveillard’s First Eagle Gold fund, for instance, rose 37.31 percent in 2001 before jumping 106.97 percent in 2002. (In 2003, as stocks rallied, gold lost ground, but in July, Eveillard’s fund remained up by more than 6 percent.)
Despite enormous gains, investors like Richard Russell believed that gold’s turn in the sun had just begun. If they were right, the upside remained steep. In the middle of 2003, gold traded at around $350 an ounce; in the me
tal’s last secular bull market, which ended in 1980, it peaked over $800. Investors bullish on “gold for the long run” focused not on the question of deflation or inflation but on the central bankers’ global print-a-thon. As long as central bankers like the Fed flooded the world with paper currency, the danger was that it would become less valuable.47
Throughout the Great Bull Market of 1982–99, the dollar had served as the world’s safe haven, with the greenback rising along with U.S. stocks and bonds. This is why foreign investors were so eager to load up on Treasuries. Meanwhile, Treasury Secretary Robert Rubin had concentrated his considerable intelligence and energies on keeping the dollar strong. At the beginning of the 21st century, however, Washington appeared content to see the dollar slide. Unemployment had risen; corporate profits were anemic. The administration’s hope was that a weaker dollar would help U.S. exporters by making their products cheaper abroad.
The danger was that the dollar’s decline would accelerate. By June of 2003, the dollar had already tumbled to a point where one euro purchased $1.13; a year earlier, one euro equaled $.92. If the dollar continued to lose value, it was not at all clear what other currency could serve as the world’s safe haven. Economic problems in Japan ruled out the yen, and despite the euro’s recent rise, the new currency seemed neither old enough nor stable enough to serve as a magnet for the world’s wealth.
Investors were beginning to move their money into real assets. “The recent rally in commodities, in gold, and possibly in real estate, are the shots across the bow for a long-term investor to shift back to hard assets in particular and commodities in general,” said Faber.48
