Update--Year End 2000
Do Old Rules Still Call For A "30%, 40%, Maybe Even 50%" Decline?

Knowing Sir John Templeton has been enriching in many ways over the years. But the year 2000 was one during which I was profoundly grateful for his favorite saying, poem and investment book.

His favorite saying is, "'This time is different' are the four most costly words in the English language." Being a serious student of financial history, John knows how often human beings have thought they've entered an utopian new age when the old rules no longer apply. His favorite poem is If by Rudyard Kipling. It begins, "If you can keep your head when all about you are losing theirs..." and ends with "you will be a Man, my son!" The year 2000 surely helped most investors to mature, both spiritually and mentally. Finally, his favorite investment book is entitled Extraordinary Popular Delusions & The Madness Of Crowds. It was written by Charles MacKay in 1852. But Sir John believes its message remains so enriching that he has arranged for the Templeton Foundation Press to keep it in print. While Sir John had never heard the words "Internet" or "day trader" at the time, he wrote this in a new foreword for the book in 1989:

"Basing our investment decisions on the actions of the crowd can be a disastrous gamble. And in this case, the 'crowd' may well include money managers and analysts well-schooled in investment theory, just as it does the amateur investor. Today, as in the time of the South Sea Bubble [in the early 1700's], human nature is drawn like a moth to flame by the speculative fads of the marketplace. The excitement of new glamour issues in electronics or medical technology, the general euphoria over a rising market, these lure even many experienced investors. Their optimism overcomes their better judgment. They abandon critical analysis of the investment's fundamental value. Like gamblers in a casino they play against the odds, paying inflated prices and dreaming of quick profit. A contemporary social psychologist uses the term 'group think' to describe the modern manifestations of crowd madness."

He then offered this counsel which has enriched investors since the cyclical fat and lean years of biblical Egypt: "You should resist the temptation to invest in any asset which would have produced the best performance for the previous five years. Instead search worldwide for some type of assets which would have produced the worst performance for the past five years and then select from that list those whose depressed prices were caused not by permanent but by temporary influences."

The vast majority of investors continue to scan those best performing lists in financial publications. But recent years have been a case study in how Sir John's "contrarian" discipline is a more enriching approach. For example, from 1995 through 1998, the large growth-oriented stocks in America's S&P 500, many of which were technology companies, were the best performing asset class. Most investors didn't realize it but that was largely due to the fact that during the previous twenty years, they had only been so one time, in 1989. Yet during 1999, most investors snapped up S&P 500 index funds so quickly that the Vanguard S&P 500 Fund became the largest fund in the country. But of course, the S&P 500 then began to stagnate. The December 2000 issue of Mutual Funds magazine reported that fully 80% of actively managed funds was again outperforming the index. It added: "Driving this change is the newfound strength of the small and mid-cap sectors, where dynamic growth companies abound but where investors have been slow to believe." International stocks, which had provided modest returns in relation to the index since they topped the best performing list in 1993 and 1994, again topped the list in 1999. And when investors began to chase pure technology funds as well as heavily promoted tech-dominated funds like Janus, Northern Trust and so on, tech was ready to enter its lean years.

Ironically, as few had mentioned it when investors were piling into S&P 500 index funds, John Brennan, the new chairman of Vanguard, offered this counsel in Mutual Funds in January: "While you may be tempted [notice his also chose Sir John's spiritual word] to buy yesterday's winners, this is frequently a loser's game. With the benefit of hindsight, we now know that the majority of investors who piled into technology funds did so too late to reap big returns. Consider that the return for the Lipper Science and Technology Fund category was a spectacular 108% from 12/31/99 to 10/12/00. But by examining the cash flows into these funds, one can see that the returns investors actually earned were a far more modest 8%. And these cold, hard numbers do not show how real people are losing real money chasing past performance." But notice that study was done before technology stocks really took a beating during the fourth quarter. Some of my clients who traded tech stocks with other brokers have shown me statements where they lost one-half to two-thirds of their money during the last four months of the year alone. And as I write in mid-February, some tech funds are off another 20% during 2001.

Watching my clients lose so much money chasing past performance is always painful. But it was particularly so this time as I had offered this counsel in the 1999 Year-End Update: "So what do we do now? In short, understand that the easy money has been made. If you missed it, be patient. Buy some bonds and real estate investment trusts for income with inflation protection. Avoid the siren song of high-risk, over-priced technology stocks. Sir John and some of my wealthier clients are actually doing quite well in a 'hedge fund' that profits from their decline. If you want U.S. stocks, stay with cheap 'Templeton-style' value stocks of primarily smaller companies or look at the dependable 'Buffett-style' growth stocks selling at far more reasonable valuations than in early 1999. Above all, manage your expectations. The latest Paine Webber survey says investors now expect 19% per year from stocks over the coming decade. [At the end of 2000, they were still expecting 15%.] Sir John became a legend by averaging 15% in far cheaper markets."

As most investors were directly or indirectly in technology stocks during the year 2000, they thought it was a bad year. Reality is that as technology stocks dropped sharply, the money moved to our bonds, real estate investment trusts, small company value stocks, Warren Buffett-style growth stocks and hedge funds, all of which had a solid year during 2000. Assuming you took advantage of this counsel from the Second Quarter Update, you also locked in some temporarily high interest rates as Chairman Greenspan cooled speculation in the NASDAQ: "For the first time in years, it could even be time to consider fixed-rate annuities from high quality companies as 7% guaranteed and tax-deferred could look pretty good." Some of you locked in more than 7% for up to ten years, which does look pretty good as the ten-year treasury bond now pays 5%.

So what should we do now? I would be most foolish not to begin with Sir John's current counsel. In his annual interview in Louis Rukeyser's Wall Street investment letter, which was conducted in December, Sir John said he: 1) "would have very little in American stocks" as the S&P is still "in dangerous territory"; 2) is "not ready to go into technology stocks" yet; 3) would only have half his bond money in U.S. bonds with the rest in international bonds; and 4) might increase his holdings of international stocks to 50% of his portfolio. He concluded: "You don't make money by doing what the crowd does. You make money by going against what the crowd's doing."

The thinking behind those four suggestions is that the U.S. dollar is "too high, and it will have to come down." That is, America may be headed for higher inflation even as its economy slows. That is a difficult condition that economists call "stagflation." America hasn't seen it since the seventies. For investors, it is a period during which international investments offer some refuge. (For consumers, it means things will cost more but you won't have more to pay for them.) International investments have been hurt by a strong dollar during the past five years as investors from around the world have moved money here to chase our currency, stocks and bonds. But they may benefit from a weaker dollar during the next five years as foreign investors leave our stock market to go back home. John Bogle, the founder of Vanguard, implied much the same in the January issue of Family Money when he said: "My guess would be that sooner rather than later, we'll get a good size bump in the market. Maybe 30%, maybe 40%, maybe even 50%. Who knows? But be prepared for that kind of a bump. If you can't handle a 40% or 50% drop in the value of your stock portfolio, you'd better think about lightening up on equities now. As for the next decade my best guess is that the net annual return of [U.S] stocks will be around 5%."

That also suggests we might keep our international and hedge-type investments but take profits in our U.S. stocks that rose to full valuation last year. Also, quality real estate investment trusts offer some refuge as they still pay 7% and may appreciate from higher inflation, which most investors haven't noticed is now rising quickly and running at nearly 4% per year. We old timers remember when President Ford launched his "WIN" or "Whip Inflation Now" campaign when it hit 3%. We know how very difficult it is to put the inflation genie back in bottle once it is out.

Chairman Greenspan remembers that too. So unlike many "new age" believers, we don't put our faith in him to automatically lower interest rates each time the NASDAQ, which may have lost over half its value but still trades at a very expensive 114 times earnings, takes another hit. The Old Rules say to honor government leaders but put your faith elsewhere. That ancient counsel may remain most enriching as investors increasingly remember that U.S. stocks only averaged about 11% this century...during which they sold at 14 times earnings on average. So as another Old Rule says: Be not afraid. But do be very careful.

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