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Single Derivative Investing

When can we once again return to the stock market with some long term confidence? What's up with bonds and global reflation? This week we continue to meditate on the risks of lazy investing and single derivative thinking, ranging far and wide in an effort to understand the world in which we find ourselves.

While you are reading this letter on Saturday, in theory I will be setting up the grill for a little weekend Texas-style barbecue with good friend Bill Bonner in his chateau (that is the French word for money pit) in Ouzilly, France. Bill is quite bearish on most things economic and political, but he has way too much fun along the way to the fin de siecle to be considered a true pessimist. (Being with Bill gives me an excuse to drink good wine and write words like fin de siecle. See more below.)

Bill is the editor of the Daily Reckoning, a daily (mostly bearish) and free commentary upon the markets. I confess to scanning it for the facts and figures from his fellow contributors, but upon finding Bill's editorial contribution, stopping to admire the artistry in his writing. He is one of the best pure wordsmiths I know. You can subscribe to it by clicking on www.dailyreckoning.com/sub/ged1419.cfm and giving him an email address.

Bill and his co-author Addison Wiggin wrote Financial Reckoning Day which actually made it to the #1 spot on the New York Times best-seller list. Amazon pairs his book and mine, "Bull's Eye Investing," for a nice combined savings. You can read more about both books, see reviews and order one or both at www.amazon.com/bullseye.

And for those of you wondering when I am going to stop incessantly mentioning Bull's Eye Investing the answer is either in late October or when the total sales of my book top Bill's. Not that there is any rivalry, of course. It is just a good benchmark to sell as many books as a #1 best seller. Right now, pretty much every mention sends it quite high on Amazon listings (it has been as high as #7) and keeps the bookstores ordering, which means that a lot of readers of this letter are still procrastinating. And now, on to the topic of the day.

Your Investing DNA

Last week we began to deal with a weekly column by CBS Market Watch writer Paul Farrell entitled, "Bull's Eye Investors Still Lose." Paul is an avowed buy-and-hold advocate, suggesting investors put their assets into a few index funds and forget about it. In his book, "The Lazy Person's Guide to Investing," he gives several portfolios from various writers and analysts, all of whom have very (stress on very) simple programs. Most of them are one or two fund investment portfolios.

For readers who might have been on vacation last week, it all started with a "debate" we had on a nationally syndicated radio show. If you would like to see last week's article, you can go to www.frontlinethougths.com and click on the previous article. I wrote about his implication that the Vanguard 500 fund would do in the next 26 years what it had done in the last 26, which is go up 20 times or 2,000%! I showed how that would mean that Price to Earnings ratios would rise to around 97 by 2030 if he was right, which is roughly four times the average high for bull markets. We talked about how his reasoning is basically one that assumes past long term performance will indicate future long-term performance.

It is "single derivative" thinking. By that I mean it takes one factor and extrapolates that factor into the future, and ignores the other factors which might affect future returns. I will quote just one section from last week, to set up this week's letter.

"In physics, we are taught to think of speed as the first derivative. The second derivative would be acceleration. If you are asked the classic question, 'A car is going 50 miles per hour. How long will it take to get to Hoboken from Miami?' it is pretty simple math. But if they throw in the curveball that the car is accelerating at 10 miles per hour the answer involves a much more complex equation. That would be the second derivative. But what if we add a third derivative and state that the acceleration is increasing at 10% every 39 minutes?

"Don't even think about fuel consumption, highway construction, if there are kids in the back seat, the age of the drivers, caffeine consumption, and other effects from the space time continuum, etc. It can get complex.

"In this case, the first derivative is simply the price of the stock market and/or mutual fund. First derivative thinking would be simply projecting past price performance into the future. And that is what Farrell does. Now, admittedly he does not say you will get 12% compound. But he implies the market over long periods of time will grow as fast as it has in the past. You cannot beat the market, so you might as well invest in the lowest cost fund which represents the market. He contends that any other choices than index funds (and bond index funds as we will see next week!) is simply wasting your time and losing you money."

Basing future returns on past price performance is single derivative thinking. He fails to think through basic value and even further what the valuations are at the starting point of the period, which may be the single most important factor. Certainly the research I've done indicates that it is.

However, Farrell only gets the silver medal in single derivative thinking. The gold goes to Harry Dent.

"By 2008," he breathlessly avers, "I see the Dow headed to a high of 35,000 to 41,000. Sound outrageous? Perhaps it does, but it is based on a standard projection using the Dow's rate of growth that began in late 1982.

"Since 1982, we have enjoyed nearly twenty years of continual prosperity that has been marred by only a few brief corrections. The Dow and the S&P 500 have increased at an average annual rate of 17%. When shown on a ratio graph instead of numerical graph like the chart below, this rate of growth appears as a channel that clearly projects a peak of around 41,000 by late 2008. This is even higher than the projected high of 35,000 that I forecast in my 1998 book The Roaring 2000s.

"And, of course, I see the NASDAQ growing at an even faster rate than the Dow and the S&P. Based on the NASDAQ channel of growth we should see it hit 30,000 plus by 2008."

A mere 20 times on your money in the NASDAQ in just 4 years. P/E ratios somewhere in the range of 1,000. How could we miss this opportunity? Normally, you would consign this type of thinking to the delusional category rather than merely single derivative. However, Dent wrote a quite cogent and major best-seller (The Roaring 2000s). He is taken seriously in many circles. But investment circles should not be one of them.

To get to this "forecast" he takes the Dow and NASDAQ charts and draws channels around the trends. (I am not making this up. You can see it at www.hsdent.com. Just click on key concepts and then to the Dow and NASDAQ predictions.)

I should note he is not an unalloyed bull. After cruising to 41,000, he then thinks the Dow drops to 10,000 around 2020-23 on its way to 250,000 in 2040. It's all right there in the charts.

Of course, if you drew the same type of charts in 1960, it would seem to indicate that somewhere around 2010 the Dow drops below 25. It's just a matter of when you start drawing the lines and what you want them to say. All such charts are backed up with some type of rhetoric. In Dent's case it is Baby Boomer spending cycles.

Much of science fiction is a speculation into what would happen if one or two current trends ended up being the dominant trends in the future. What if the Greens came to control much of known space? What if the religious right did? What if they became one and the same movement? L.E. Modesitt (in The Parafaith War series) speculates about such things. But he at least calls his work fiction, and investors do not lose money if he is right or wrong. And readers get to be entertained.

In essence, what Dent does is take one derivative of future investment returns, in this case past price performance, and project it into the future. His favorite medium is charts rather than science fiction, although the end result is the same, if not as entertaining.

What's Up/Down/Sideways with Bonds?

But back to Farrell. In his book, Farrell praises bond index funds. His ideal portfolio is the Couch Potato portfolio, spread between the Vanguard 500 index and the Vanguard Total Bond Mark Index. Either 50-50 or the more (quote) Sophisticated Couch Potato allocation of 75 stocks-25% bonds will do just fine.

I have been a big fan of bond funds for a very long time. Remember, bond funds are marked to market every day, and fluctuate (sometimes significantly) as interest rates move. Bonds become more valuable as interest rates drop. As long as interest rates were generally headed down, bond funds captures the capital gains as the bonds within them increase in value. The opposite happens when rates rise.

Let's go to the Vanguard website for a quite reasonable analysis of the risk of bond funds in their July, 2004 Plain Talk Bulletin. They create a hypothetical portfolio bond fund with a yield to maturity of 4% and a duration (the average maturity of the bonds) of just 5.8 years. If rates rise by 1% a year for the next two years, your total return for the two years is going to be a -0.4%. If rates then hold steady your return in year three would be 6%, as they would be buying new bonds at a higher rate to replace the ones which reach their maturity and are repaid. You annualized return is 1.8% for the three years.

Of course, if rates drop by 1% per year for the next two years, your total return is 8% per year for the first two years and just 2% thereafter. You live by the sword and you die by the rate increase.

Now, if you hold for seven years, you will eventually be better off (yield wise) in a rising rate environment. But for the first five years you would not be getting the 4% total return that you thought you had signed up for. If you pull 4% out per year for the first two years as income, you are down almost 9% in your principal. If you keep pulling out 4%, it will be over ten years before you "break even" or get back to your original principle. (Of course, assuming that rates will be steady, which they will not be.) That type of volatility is not what investors think of when they think bonds.

The question is, of course, which way are rates headed? UP is the natural answer. And the smart guys at Bridgewater Associates agree. But they are a little mystified that rates are not already higher. Inflation and commodity prices are up smartly since January, but yields are roughly where they were at the beginning of the year. What they call the 10 year "break even implied inflation" and oil prices had been pretty much tracking each other since the beginning of the year, but then oil soared while implied inflation actually dropped. They write:

"Interestingly, both the real yield [yield over inflation] and implied inflation components that are embedded in bond yields are at about the same levels as they were at the beginning of the year. Between the two, it is more surprising that break-even inflation rates (implied inflation) have not risen this year.

"As we have noted in recent Daily Observations, when commodities prices (led by oil) rose earlier this year, break-even inflation rates rose with them. But recently, as many commodities prices have continued to rise, break-even inflation implied in bond yields has actually fallen quite a bit. Though the divergence was caused by a small cooling of economic growth, we don't think the pricing makes sense overall. Of course it is possible that commodities prices only reflect short-term inflation pressure, whereas implied inflation in long-term bond yields is a reflection of long term inflation.

"It's thus the pricing of inflation embedded in bond yields that seems most out of whack to us, and is very much inconsistent with the pricing at the beginning of the year. If bond yields rise, we think it will be for this reason. But the best way to take advantage of this pricing is to be overweight TIPS and underweight nominal bonds."

The smart research group from the Netherlands, ECR, tends to agree.

"Over the past week the oil price seems to have turned. Still, we think that in the first instance bond yields will climb quite slowly, and may initially even drop somewhat further. Due to the high oil price, by now two months have passed when employment only increased very slowly. In addition, many companies will want to see that oil prices continue to drop over a period of time before they start to believe that this is not just a temporary correction. In other words, businesses will not start to take on new people and invest more of their money straight away.

"For the time being, we assume that the Fed will raise its rates once or twice, by 0.25%, in the course of this year. Should the oil price first start to soar considerably before it really turns, the 10-year yield on US Treasury bonds (now at around. 4.25%) could subsequently start to drop further to around 4%. However, if the oil price does not become much higher, we think that the 10-year yield is more likely to stay around the current level over the coming period. In either case, we think that economic growth will sooner or later start to creep toward 4% again. As soon as this becomes visible, in our view the US 10-year yield will start on a climb toward 5.25%-5.5%."

The Second Derivative of the Bond Market

OK, it's all set then. Interest rates are going to rise. But then again, what if the bond market is telling us something else? Maybe the reason longer term rates are not rising is not all that benign. What if it's saying the slowing of the economy is not a one quarter break, but a trend? What if it's looking out over the next year and sees a slowdown coming, which would make the lower interest rates of today make sense?

What if, and I speak a heresy to many of my readers, maybe-perhaps-possibly our old nemesis, that which Greg Weldon calls the Wicked Witch of Deflation, is not really truly good and dead? What if gold is not forecasting inflation but simply more dollar weakness?

There are signs of her (deflation) survival lurking in the details of financial reports here and there. There is weakness in the income figures. Incomes rise by a mere 0.1% while consumer spending rises 0.8%. Personal savings, and total US savings, is at an all-time low. Housing inventories are rising and sales are slowing. Capacity utilization is still quite low. The employment numbers tease us with a little jump and then drop back to disappointing. Consumer confidence and business confidence polls are slipping.

Maybe it is the dog days of summer (which refers to the dog star Sirius being ascendant and not to your pet lolling on the back porch to escape the heat). Maybe it is a response to a constant barrage of democratic ads telling us how bad things are. But maybe it is something more.

(Right after Labor Day, we are going to launch my new letter, Outside the Box. It will feature the writing of people and friends who will help us see things from a different point of view. In that regard, I have asked Dr. Gary Shilling to do an in-depth article on why he thinks that the CPI actually overstates inflation and that deflation is still the issue. It is not conventional Wall Street wisdom, but it is Outside the Box. I hope he is done so we can launch with it.)

Sometime within the next two years, I think I will be able to dust off my old columns on deflation, add a few updates and use them again. Recessions are by the very nature deflationary events. If we go into a recession within the next two years, we may once again be flirting with deflation. The Fed will fight deflation with every tool it has. That is why I think the end result of the whole process will be a return to stagflation - rising prices and a Muddle Through Economy. We will cover that in future letters, but let's return to bonds and single derivative thinking.

Farrell write in his column: "99 percent of American investors are born with buy-and-hold DNA, they are passive investors who rely on well-diversified portfolios often of low-cost index funds. They don't have the time, money or interest in active portfolio management, nor do they trust in the market or in professional market experts.

"Meanwhile, the DNA of the other one percent, the so-called 'Bull's-Eye Investors,' contains a rare overconfidence gene that pumps an 'I-am-convinced-I-can-beat-the-market' drug directly into their brains. Of course the odds are against them beating the market, but that gene contains a blocker that suppresses negative information."

Americans have just come through over two decades of the most remarkable investment climate in history. A perfect combination of falling interest rates and inflation, the introduction of new technologies, rising valuations, lower taxes, boomer spending and dramatic increases in productivity. Up until a few years ago, buy and hold worked.

But it worked not because it is a superior investment strategy for all times, but because it was the right strategy for that particular period.

Paul is wrong. Americans are not born with a buy and hold gene. They are born with a gene that looks to their past experience and extrapolates that into the future. It is far more like a single derivative forecasting gene. It is called anchoring and fixating, and it is a useful survival trait in the wild, but dangerous on Wall Street. If you were a Depression baby, your gene is not buy and hold.

Our past experience tells us buy and hold is good. But study into historical market cycles tells us market valuations are the true key, not past experience.

Bonds are a wonderful thing. But today if at all possible I would want to own the bonds directly, not through a fund. You can create your own laddered portfolio. Over time (perhaps a long time if rates rise more than a few points) that bond fund will do well, but holding the actual bonds will outperform the bond fund in a rising rate environment in a total return market.

Yes, it is more work or it requires a professional if you do not want to do it yourself. It is especially important if you are retired and living off the income. You must protect the principle in such a circumstance.

Farrell is right in that if you have 20 years, a low cost bond fund will serve you well. But owning the bonds will serve you better. As an aside, if you are in a 401k plan and simply do not have the possibility of buying individual bonds, I would pick a short to intermediate term bond fund with the lowest possible costs. Time will heal the costs of rising rates as the rising rates will increase your yield.

And What about the Stock Market?

And as to his last assertion that Bull's Investing is about beating the market, he misses the point. Perhaps if he had read the book he would have realized that I am not about beating the market. I just don't want to let the market beat me to a pulp.

Buy and hold investing in periods when the stock market is highly valued is a prescription for investment pain. As Shiller, Alexander, Easterling, Grantham, Buffett and others have shown, valuations matter. As Professor Shiller (of Yale) clearly documents, investors who buy in periods of high valuations would have been better in money market funds for the next ten years.

A recession is going to knock stock prices down. Stock markets fall on average about 43% in a recession. Just like I prefer to buy cars or books or sheets when they are on sale, I want to buy stocks when they are on sale. I want to buy them when they are cheap.

There are some cheap stocks out there today. But there are no cheap indexes. A patient long term investor could wait until valuations drop below the long term average of 15 and begin to feather into the market. More aggressive value investors might like to wait for lower valuations on the indexes, or until the next recession as things get ugly.

You can either do your homework and try and avoid letting the market beat you. Bull's Eye Investing, if there is such a thing, is about beating zero, not beating the market. It is about letting value be your guide, not the recent historical experience of the greatest market bubble in history.

If you want to be a lazy investor, you will get a lazy investor's reward. But that might keep you working for longer into retirement than you planned.

Off to London and Other Fair Climes

My friends at Absolute Return Partners in London tell me I need to bring a little spare sunshine from Texas. I am not quite sure how to get that through security, but I will try. This looks to be a busy trip, and I will need to read and write a lot. I am behind on my writing for the Accredited Investor E-Letter. I put the final touches on one this week, but need to immediately start another.

If you are an accredited investor (basically $1,000,000 or more net worth - see the website for details) and would like to get this free letter on hedge funds and alternative investments you can go to www.accreditedinvestor.ws and subscribe. In conjunction with my friends at Altegris Investments, we offer a number of funds, both private and public, for the accredited investor. In this regard, I am a registered representative and president of Millennium Wave Investments, a broker-dealer registered with the NASD.

The final details are on the web for Telecosm 2004, hosted by George Gilder and Steve Forbes at Lake Tahoe, Nevada on October 20-21 at www.telecosmconference.com. Telecosm 2004 has a pretty powerful line-up of speakers, especially for those interested in technology. George writes me that: "Any of your subscribers registering though the link below will receive over 80% off the conference list price of $2,995, plus qualify to register a guest for FREE (if registered before Sept. 17, 2004). http://www.gildertech.com/public/Mauldin-Subscriber-Offer-2004.htm." Now there's big discount just for reading this far in a free e-letter.

It will be interesting to get a brief feel for the political climate in London and Paris. I am told that a Republican from Texas is considered rather an oddity, something more for a museum than for the local pub. I know (because you write) that many of my non-US readers simply cannot understand the political process in the US. It seems like it should be so obvious when viewed from the Continent. It will be interesting to see it from there. It is a strange new world.

I always enjoy spending time with Bill. He stimulates my thinking. I have a few questions for him as well. I have been meditating of late upon the possibility that we are indeed at an inflection point in history, those times when things and trends change. Can we discern in advance the nature of the change, get a sense of where the acceleration of trends, that second derivative, might be taking us? If it is not too convoluted, and if we limit the wine intake, perhaps it will make for an interesting future letter.

Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA) a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. MWA is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Funds recommended by Mauldin may pay a portion of their fees to Altegris Investments who will share 1/3 of those fees with MWS and thus to Mauldin. For more information please see "How does it work" at www.accreditedinvestor.ws. This website and any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement or inducement to invest with any CTA, fund or program mentioned. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Please read the information under the tab "Hedge Funds: Risks" for further risks associated with hedge funds. Your wondering what it all means analyst,

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