Update--May 2, 2002

Ancient Theology & Modern Portfolio Theory

What we call "modernity" essentially began a few centuries ago with the separation of science and religion. The new "post-modernity" is not only characterized by that separation but by the separation of church and state, as well as the separation of church and estate. So most people in the West think it's odd for us to mix religion and investing. Few realize that everyone has a religion, in the sense that they have ultimate values--be they God, money, power or pleasure. All investors therefore have underlying beliefs, whether a belief in the growth and technology preached by the analysts and fund managers of Wall Street over recent years or the prudence and ethics preached by evangelists and scriptures of religions over previous centuries. While most of us view as quaint the mountain-top tests between the Old Testament prophets and the priests of ancient pagan religions, we have seen one in recent years that has been of biblical proportions.

Investing, like religion, is simply the art of discerning reality from illusion, truth from error. So for several years now, this newsletter has tried to help its readers to prudent gains by recommending bonds, small value stocks and real estate investment trusts rather than go-go stocks. It has preached that "the first rule of investing is not to lose money...and the second rule is not to forget the first rule." In particular, it has cautioned all the new converts to the religion of the two-faced pagan god Janus--as well as its fellow former gods of short-term performance like Putnam, Fidelity, Northern Trust and so on--that they shouldn't place too much faith in the modern portfolio theories preached by Janus. Beginning with our Updates in 2000, we preached the old religion that p/e ratios may not be commandments written in stone but are still proverbial if you pursue the riches of Solomon. And we taught the golden rule that companies must do something of value for other people in order to create value in themselves. As one company engineered for short-term, illusory profits after another goes bankrupt or restructures, investors everywhere have been humbled. Of course, a humble spirit was the prerequisite for the ancient religions; a pride in human thinking was the cornerstone for the modern one. Humility is returning as people have repented.

The April 15th Wall Street Journal reported that the Fidelity Magellan Fund and the Vanguard Index 500 fund, the two largest equity funds in America, have now lost 5.3% per year over the past three years as they were loaded with tech stocks in 2000. (The old reliable but largely neglected Templeton Growth Fund has averaged a gain of about 8% over the same three years as it avoided the once hot tech stocks.) Those once-hot fund groups have lost tens of billions in assets and caused a lot of sleepless nights. Sounding like Moses viewing the golden calf at the base of Mt. Sinai, the most recent Barron's looked at Putnam and said: "By the late nineties, Putnam's most aggressive funds were at the center of the tech-investing orgy, riding momentum stocks and, thanks to the firm's impressive performance numbers, drawing in loads of money from investors." The chief executive of Putnam humbly confessed: "a lot of people here were feeling pretty proud. It would be right to say in retrospect we probably weren't as good as we seemed."

The 1999 Updates questioned the prophecies of those investors in the annual Paine Webber survey who were expecting 19% annual returns from stocks during this decade. (If you want to review those Updates, they're on www.spiritualinvesting.com). After 9/11, investors were still expecting 13.5% but now they're expecting 9.5% over the coming decade. My guess is that, as in 1990, American stocks probably won't begin another serious and sustained bull market until we again think that someone like Japan is going to buy us after our government and corporations go bankrupt. That is, investor expectations may still be too high with p/e's where they are.

Even the Wall Street Journal has been humbled. On April 18th, it stopped publishing its famous "Dartboard contest." For fourteen years, Journal readers submitting their best ideas and Journal staffers throwing darts at the stock pages were pitted against professional investment managers--who are often the object of considerable skepticism on the part of Journal reporters. The contest was put together fourteen years ago because a now famous book by an academic, who had probably never managed money himself, said "blindfolded monkeys throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts." During the two-decade long bullmarket, that cynical sentiment encouraged many readers to try just that by day-trading, gravitating to index funds and so on.

Yet after 142 six-month contests, the results were that stocks picked by the pros gained 10.2% while the darts managed just 3.5% and the Dow gained 5.6%. Interestingly, Journal readers lost 4% during the thirty contests they participated in. While it may not be what the Journal had hoped to prove, it seems that if investors aren't going to seek professional help, they'd be better off to employ blind-folded monkeys than read the Journal. Remember that Wall Street Journal readers, particularly those brave enough to challenge the pros and enter a published contest, often see themselves as the sharpest investors around. And we've all seen those ads about how easy it is to make money if you read the Journal. Such illusion may be why Sir John Templeton, who has long said that making money is never as easy as financial writers and academics assume, encourages investors to avoid the financial press.

Finally, many once prideful corporations have been humbled. The "Update--First Quarter of 2000" described an ad from Sun Microsystems featuring a soaring skyscraper and the line, "In The Net Economy The Sky Isn't The Limit, It's A Ridiculously Low Expectation!" I mentioned it seemed a modern Tower of Babel, due for a fall. Sure enough, the president has just resigned as the stock has fallen 90%. One reason I don't think such bloodied companies will mend overnight is that while the attorney general of New York predictably now has tech analysts in his sights, even the companies' one-time friends seem to be smelling blood rather than applying tourniquets. The April 29th issue of Forbes contained a story headlined, "High-tech companies and their investment bankers have a cozy symbiotic relationship regarding stock options. Caught in the crush is a new victim: the worker."

That sounds more like something Karl Marx would write than something The Capitalist Tool would publish. But the story's tone--and the furor over Enron, Global Crossing, Worldcom and so on--reminded me of these prophetic words from Dr. Peter Drucker. Forbes published them way back on March 10, 1997: "In the next economic downturn there will be an outbreak of bitterness and contempt for the super-corporate chieftains who pay themselves millions. In every major economic downturn in history the 'villains' have been the 'heroes' during the preceding boom...Few top executives can even imagine the hatred, contempt and fury that has been created--not primarily among blue-collar workers who never had an exalted opinion of the 'bosses'--but among their middle management and professional people. I don't know what form it will take, but the envy developing from their enormous wealth will cause trouble."

Most of corporate America appears ripe for the anger of managers and investors. The Economist magazine has recently reported that: 1) "corporate profitability has fallen to its lowest level since the depression of the 1930's" and 2) "the companies that make up the Nasdaq 100 index together reported $19.1 billion of profits in pro-forma earnings announcements for the first three quarters of last year...those same companies reported to the SEC a total loss for the same period of $82.3 billion. The difference, $100 billion give or take, is down to the fact that, whereas the SEC numbers are audited and comply with American generally accepted accounting principles (GAAP), pro-forma numbers should be treated with deep skepticism." In other words, most investors in the Nasdaq have been blindly ignoring p/e ratios. Once they repent and return to the old religion, investors probably figure p/e ratios based on greatly inflated earnings estimates passed on by the company. But as one telecom company after another restates earnings and/or declares bankruptcy, investors begin looking for GAAP earnings produced by auditors. But after Enron and Arthur Anderson, investors no longer trust even them. When they discover even the most conservative p/e ratios may be unreliable, many investors will simply further lighten up on stocks. From such are the side-ways markets we anticipate made.

So what do we do? My guess is to continue investing in the bonds, reits, and hedge funds that are non-correlated with the U.S. stock market. Medium grade corporate bonds pay over 9% and appear good for those who normally assume the risks of the stock market. International stocks look better than domestic stocks. A special section in the April 29th BusinessWeek began, "For the past decade, investors have had little reason to buy stocks of non-US companies. During the bull market, far more money could be made at home, and when the bears took hold, most foreign markets fell victim too. But the next decade could be quite different. Stock valuations in most foreign markets are now significantly lower than in the US and earnings potential is often just as good abroad as it is at home. Any weakness in the long-strong US dollar will make nondollar investments all the more rewarding." As the mutual fund rankings demonstrate, that would have been terrific advice three years ago. But it's still good advice today.

Economic cycles are usually measured better in terms of decades than years. In 1990, when I wrote my first book encouraging Americans to buy our stocks, they had less than 20% of their assets in them. By the end of the decade when I wrote to ease up on them, they had over 46% of their assets there. They now have about 33%. I'll look more seriously at our stocks when that number has fallen to 25%, which is the historic norm, or lower. That may take a few years. But trust remains the lubricant of capitalism. And America is running low on it. That may keep the machine running slower than many investors expect for longer than they expect. As the children's song says, the Bible tells me so...even if few analysts and fund managers do.

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