Bull's Eye Investing

Tonight, per my Friday evening habit, I will print out a newsletter that I consider must-reading every weekend. It happens to be free, but I guarantee you the author could charge upwards of $200 per year and retain the vast majority of his 1.5 million readership. His name is John Mauldin, and I rate him as one of the top investment thinkers around.

What I especially appreciate about Mauldin's e-letter is that it provides me with intelligent perspective on the Big Picture that I, as a bottoms-up stock picker, would otherwise miss. Each week, Mauldin reads literally hundreds of reports (many of them are high-dollar subscriptions) on everything from economics to behavioral finance, from politics to demographic trends. Then on Friday afternoon, in what must be a blitzkrieg on the keyboard, he synthesizes it all into an articulate report that typically runs seven printed pages. Each issue carries the reader one step closer to understanding today's investment landscape and, significantly, how it might change tomorrow.

By now you might be thinking, "Hey, isn't all that macro-schmacro stuff just a waste of time? The world economy is far too complex for any one person to grasp entirely." Granted, the macro equation presents a bewilderingly complex set of puzzle pieces -- but Mauldin just happens to be exceptionally skilled at assembling those pieces. His track record proves he's an exception to Peter Lynch's quip that "10 minutes per year studying the macro economy is 10 minutes wasted." Consider the following examples.

In late 2000, Mauldin correctly discerned that the inverted yield curve was signaling a coming recession and that investors should clear out of the stock market. In 2001, he further warned readers that U.S. stocks were likely entering a decade-long secular bear market (more on that in a moment). Then, in March 2002, after years of being negative on gold, he turned bullish on the yellow metal as a way to benefit from a declining U.S. dollar.

These are but a few of Mauldin's profitable insights from the past several years. When I first encountered Mauldin's writing in early 2003, I so enjoyed his analysis that I was motivated to read back through his online archives dating back to 2001. You can still do that (and it's free), but now there's a better way. All of Mauldin's analysis and opinions are packaged and updated in his just-released book, Bull's Eye Investing: Targeting Real Returns in a Smoke-and-Mirrors Market.

This is a must-read book for serious students of investing. Broadly speaking, the first 15 chapters are on trends in the stock market and economy, while the final nine chapters offer investment strategies for successfully navigating those trends. The largest of these trends -- and I happen to agree with Mauldin on this point -- is that we're in a secular (i.e., long-term) bear market.

Think really long term
This is not -- repeat, not -- a doom-and-gloom prediction, nor in any way a doom-and-gloom book. Mauldin makes it clear he's optimistic about America's future. He expects the economy to do OK -- "muddle through," as he puts it -- albeit with a couple of recessions over the next decade. The root cause for Mauldin's bearish outlook is the stock market's historically high valuation, along with where we are in terms of historical market cycles.

Regarding these cycles, Mauldin writes:

Since 1800, traditional analysis suggests there have been seven secular bull markets and seven secular bear markets. The average real [i.e., inflation-adjusted] return in a secular bear market is 0.3% (even in a falling market investors receive dividends). The average return during a bull market cycle is 13.2%. Not coincidentally, this averages out to the 6.7% the Ibbotson study (among many others) tells us that stock investments return over the long haul.... The average length of bear markets is almost 14 years, and for bull markets is almost 15 years. The average complete cycle of a combined secular bull and bear market is 28 years.

Just from observing these average cycle lengths, I draw a couple of conclusions. First, it brings a new clarity to what truly defines "long term" in the stock market. Unless your investment horizon is 28 years or more, you may not be able to afford to just "ride through" the market's ups and downs. Second, considering that the last secular bull market ran longer than average at 19 years (1981 to 1999), are we to believe that we're already positioned for another secular bull?

The market's rally since October 2002 has suckered most investors into thinking a new bull market is underway. Not so, says Mauldin: "Some will say, as they say each year, that the bear market is over, that this book is writing about ancient history. But history teaches us that is not the case. Secular bear markets can have drops much bigger than we have already seen, and last for up to 17 years.... They have never been over when valuations have been as high as they are today [emphasis mine]."

The proof is in the P/E
This is a valuation argument based on 100 years of stock market history. In chapter five (the book's most crucial chapter, in my opinion) Mauldin and co-author Ed Easterling analyze every secular bull and bear market since 1900 (there were four of each). Their key finding was that every bull market was characterized by P/E ratios that started from a low level and rose to a high level, while every bear market was precisely the opposite. The results, based on research by Easterling's firm, Crestmont Research, are summarized in the chart below:

Starting P/E*

Ending P/E* Cumulative Return**
1901-1920: BEAR 23 5 1.4%
1921-1928: BULL 5 22 316.7%
1929-1932: BEAR 28 8 -80.0%
1933-1936: BULL 11 19 200.0%
1937-1941: BEAR 19 12 -38.3%
1942-1965: BULL 9 23 773.0%
1966-1981: BEAR 21 9 -9.7%
1982-1999: BULL 7 42 1213.9%


The P/E ratio is based on the S&P 500 as developed and presented by Robert Shiller in Irrational Exuberance.
** The returns reflect the Dow Jones Industrial Average at year-end.

Source: Crestmont Research

Mauldin and Easterling conclude that "The critical factor is to notice that at the start of each bull cycle the markets had single-digit P/E ratios, with no exception. No secular bull market has ever begun with high P/E ratios, even though there have often been significant rallies from high P/E ratios. The lesson of history is that all periods of high valuations came to an unhappy end."

So what's the status of today's market valuation? Well, Standard & Poor's is calling for S&P 500 core earnings to reach $52.60 for 2004. With the S&P 500 currently near 1140, that's a P/E of 21.7. History suggests that's nowhere near low enough to fuel a sustained bull market.

From that perspective, the market's rally since the October 2002 lows can be seen for what it really is: a bear market rally. Mauldin reminds us, "Even in secular bear markets, the stock markets rise in 50% of the years." After three consecutive down years from 2000-2002, the odds were on the bulls' side in 2003. But going forward, odds and history favor the bears.

So what do you do?
Mauldin favors absolute-return strategies: "Bonds, dividends, income-producing partnerships, certain types of hedging strategies, and covered call option selling would be examples of absolute-return strategies. Will these give you 10% to 15 % a year? Not likely, but they will outperform stock market investments that are going down or sideways."

Mauldin even devotes several chapters to strategies for identifying the type of deep-value stocks that can excel in a bear market. He cautions readers, however, that "Owning stocks in a secular bear market requires great skill in stock selection. I am perfectly willing to concede that there are hundreds of stocks that will double over the next few years. The problem is that there will be thousands of stocks that will drop by 50%. Choose wisely."

Sound impossible? It's not, if history is any guide. And based on the dearth of values I'm finding in my bottoms-up research, I have that much more reason to believe Mauldin is right. I wholeheartedly commend Bull's Eye Investing to the serious investor looking for an edge over the coming decade.

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Guest columnist Matthew Richey has been a longtime contributor to The Motley Fool and is a portfolio manager at Centaur Capital Partners LP, a money management firm based in Dallas, Tex. Please send your feedback to mrichey@centaurcapital.com. The Motley Fool is investors writing for investors.


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