withalong with your book.”
Chapter 1 • The Meme
37
We wonder whether the chairman scrupled to return the book by the professor of irrational exuberance, Robert Shiller, who told us he sent a copy to him.April 4, 2001: When a plague overwhelms a city, people trying to escape onlycarry the disease to new places. So, too, the market has resumed its slide. Thevalue of the U.S. stock market has fallen by $5 trillion—31 percent—in justover a year since its March 24, 2000, peak. It makes us feel so weak, so ignorant, so small. But that is what the Meme wants!August 31, 2001: I awoke from a restless sleep last night and heard a chillingvoice chanting in the corner of my room: “You can’t trust yourself, can’t trustthe Street, can’t trust the CEO, can’t trust your broker, can’t trust the market.”I turned on the light. The voice fell silent. No one was there.September 15, 2001: Unspeakable horror. On September 11, a group of Islamicfanatics destroyed the World Trade Center and one side of the Pentagon, thevery heart of America’s military power. Everyone is in a state of shock, practically immobilized by fear. The attack destroyed communications links inlower Manhattan, the location of the New York Stock Exchange, and the market has shut down indefinitely. All airliners and crop dusters have beengrounded. Nobody wants to leave home anyway. In Manhattan, the few openhotels, restaurants, and theaters are deserted. The terrorists are the very onesPresident Clinton failed to deal with after the attacks on our embassies.September 16, 2001: A strange trio appeared on television today. Robert Rubin,Jack Welch, and even Warren Buffett are on the side of the bulls. Rubin “seeslong-term strength,” and Welch says the United States is “the best place in theworld to invest.” With reluctant optimism, the Nebraska icon himself opinedthat it would be “crazy” to sell stocks now. If only he had not added: “If priceswould fall significantly, there are some things I might buy,” he might havehelped stanch the market’s hemorrhage. Then again, there are rumors that ifthe market declines, Buffett will make $500 million. I am not relieved, butfrightened and haunted, by what this trio has said.Then there are the eerie charts. Loews Corporation reportedly lost hundreds of millions of dollars in the last half of the 1990s by betting on marketdeclines. Loews Co-Chairman Lawrence Tisch often perused a chart showingthe Dow at the time of the 1929 crash and Japan’s Nikkei when it began itstumble from 40,000 to 10,000. The chart now finally bears a macabre resemblance to the Dow and Nasdaq.September 21, 2001, Morning: Last night, President Bush gave what many calledthe finest American presidential address ever. He said that our grief hadturned to anger, and our anger to resolution; that we would bring our enemies
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Practical Speculation
to justice, or bring justice to our enemies. The market shot up on his speech.But then the Meme called on one of its brothers in France to explode a chemicals factory. With the terror that had already spread, the explosion was morethan enough to cause the greatest decline in market history.I was short the naked put, and there was a special open that might havekilled me. My brokers seem to be cousins with the Meme, and ordered me tocover up my nakedness.September 21, 2001, Evening: Ah! The Meme would make of us what we havemade of the horse and of the ox: its chattels, its slaves, its food. Woe to us! Butnevertheless, the animal sometimes revolts against the one who has subjugated it. . . .The little nail can topple an empire. But the empire, when it knows that itneeds to protect itself, can fight back and accomplish marvels. Scientists firstsplit the atom to beat the Nazis. The countries of the world have finally awakened to the fact that if they do not defend the technology and the trade that arethe Western way, then freedom itself will vanish. The market gained back almost everything it lost during the day. The brainwashing of the West by theMeme has ended. I predict that there will be a gigantic rally in the market fromthe Dow 8235 level reached today, and that the Meme, like Frankenstein andmany other monsters, will die in the fire that looked to be its greatest victory.January 8, 2002: The Dow is now at 10,150, in an abundance of delight. Theputs that were selling at 100 to 200 have gone down to pennies. It is the sameas with the Thai banks that I owned during 1997. But this time, I am short,not long, and the profit is mine, and the loss is the Meme’s. The Meme hasblown itself up. It is dead.March 9, 2002: I look at the morning newspaper. A headline catches my eye:“Buffett: ‘No feasting on this market.’ ” I read on. “‘Our restrained enthusiasm for these securities is matched by decidedly lukewarm feelings about theprospects for stocks in general over the next decade or so,’ Buffett wrote in hisannual letter to shareholders. ‘Charlie [Munger] and I believe that Americanbusiness will do fine over time, but think that today’s equity prices presageonly moderate returns for investors.’ ”14No . . . no . . . no! Without a doubt, the Meme is not dead! When will itdie? Only when people realize they must think for themselves: To count forthemselves. To believe in their abilities to create. To live longer and better. Tolend money to the men and women with the good ideas.March 31, 2002: The market is up almost 20 percent from the low it set afterthe World Trade Center attack last year. Perhaps the Meme and his darknessare finally gone.
Chapter 1 • The Meme
39
July 23, 2002: I am so sad I can hardly get out of bed. I sleep to escape theMeme, who now seems to rule my waking hours. I bought stocks after thepanic last September, and neglected to sell them before going abroad. Uponmy return several months later, I find that my accounts have dwindled to pathetic shadows of what they were. I am afraid, deeply afraid.September 10, 2002: Tomorrow is the anniversary of the World Trade Centerattack, and everyone is in dread that something even more terrible will happen. A dirty bomb, perhaps, spewing radiation? S&P futures rise 10 pointsand close at 911. Today’s New York Lottery numbers are 9-1-1. Any rationalperson would call them coincidences. But maybe we have gone beyond rationality. Maybe the Meme has signed his name.September 17, 2002: A thousand unspeakably horrible stories of evil hidden inthe lights and flash of the 1990s boom are crawling out, pulled out of the darkness by prosecutors and the media. Dennis Kozlowski, the CEO of Tyco and agolden boy of corporate America, has been indicted with his chief financial officer for bilking the company of $600 million. According to the company’sown SEC filing, Kozlowski billed Tyco for his wife’s $1 million birthday partyon the island of Sardinia. The details included a welcoming line of gladiatorsand a waiter pouring Stolichnaya vodka into an ice sculpture of a boy with theliquid dispensed through the penis. The Kozlowskis did invite a few Tyco executives, and regarded it as a business expense.The Meme loves it. I can hear its sarcastic laugh.October 2, 2002: Hardly a week has gone by this year without a fresh disclosureof secret deals, false earnings statements, or frauds committed in broad daylight under the noses of corporate directors. The U.S. Justice Department hasopened more than 400 investigations into possible corporate fraud since thebeginning of 2000, and has charged more than 500 people with corporatecrimes. Enron’s chief financial officer has made a court appearance in handcuffs, as have Tyco’s CEO and CFO. The former controller of WorldCompleaded guilty to cooking the books to come up with $5 billion in fraudulentprofits, and is facing a five-year prison term. More analysts are under investigation nowadays than are writing research reports—not that anyone believesthe reports any more.Global Crossing, WorldCom, Enron—all golden 1990s stocks, all bankrupt now. The Meme feeds on the news. I sense him growing stronger andbolder. He has made the stock market his food. Just looking at the numbersmake my head ache. Nasdaq: down 3,908 points from the high of early 2000to the low on October 4, 2002. The Dow: down to 7,528 from 11,700.
Time Line of a MemeDate
Action
December 5, 1996
Federal Reserve Chairman Alan Greenspan opens Pandora’sbox with “irrational exuberance” speech; makes case fortargeting the market ’s “wealth effect.”
October 20, 1997
U.S. Justice Department sues Microsoft for requiringcomputer makers to install the company ’s Internet Explorerbrowser if they want to license Windows 95.
May 18, 1998
United States, 20 states file antitrust case against Microsoft.
August 7, 1998
Bombings of U.S. embassies in Nairobi, Kenya, and Dar EsSalaam, Tanzania.
August 20, 1998
President orders retaliatory bombing of Osama bin Laden basein Afghanistan; bin Laden leaves one hour before attack.
July andSeptember 1999
Warren Buffett, in private speeches reported in November byFortune, says he would have shot down Orville Wright ’s planeas a service to capitalists, predicts years of poor performancefor U.S. stocks.
November 5, 1999
Judge Thomas Penfield Jackson rules Microsoft usedmonopoly power to stifle innovation.
February 17, 2000
Greenspan signals further increases in interest rates; saysstock market gains may create more demand for goods thancan be supplied.
February 18, 2000
Boiler Room, a film about a shady brokerage that cheats naïveinvestors, released. “A thoroughly enjoyable movie which doesan excellent job showing us how the lust for money cancorrupt us all,” wrote critic John Beachem.
March 1, 2000
Warren Buffett writes in annual report to Berkshire Hathawayshareholders that “Equity investors currently seem wildlyoptimistic in their expectations about future returns.”
March 8, 2000
Al Gore wins Democratic presidential nomination, inveighsagainst big business.
March 10, 2000
Nasdaq peaks at 5048.
March 14, 2000
President Clinton and U.K. Prime Minister Blair call forimmediate public access to raw genetic data collected byprivate companies. “Our genome belongs to every member ofthe human race,” Clinton said. “We must ensure that theprofits of human genetic research are measured not in dollarsbut in the betterment of human life.” Nasdaq falls 200 to4706. “Being a business seems to be an awful thing today,”says Craig Venter, founder and president of Celera, a genomics
40
ContinuedDate
Actionfirm. “Instead of celebrating that a public company is doingthis and releasing it for free, they are complaining because acompany is doing it faster than they are and for less money.”
April 2000
Robert Shiller, an economist who briefed Greenspan two daysbefore the “irrational exuberance” speech, publishes book ofthat name, becomes instant media star.
April 3, 2000
Judge Thomas Penfield Jackson rules Microsoft violatedantitrust law. Nasdaq drops 349. Next day, Nasdaq falls 575 to3649; rebounds to close at 4148.
October 12, 2000
Suicide bombers attack the USS Cole in the Yemeni port ofAden.
November 7–December 13, 2000
United States gripped with uncertainty as Florida presidentialelection ballots are counted and recounted. Gore concedeselection to Bush on December 13. Nasdaq loses 17% in theintervening five weeks, S&P drops 5%.
September 11, 2001
Islamic terrorists destroy the World Trade Center, WorldFinancial Center, and much of lower Manhattan; Pentagonattacked.
September 21, 2001
U.S. stocks conclude their worst week in 70 years.
December 2001
Enron files for bankruptcy protection.
January 2002
Global Crossing files for bankruptcy protection.
June 2002
Adelphia files for bankruptcy protection. CEO arrested onfraud charges.
June 2002
Arthur Anderson convicted of obstructing justice in Enronfraud case, can no longer audit public companies.
July 2002
WorldCom files for bankruptcy protection. CFO and controllerarrested on fraud charges.
September 2002
Tyco’s former CEO and CFO charged with looting the companyof $600 million.
41
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Practical Speculation
Ah, I understand it all now. The Meme knew all along that the contagiousoptimism of the 1990s had left no one able to withstand a decline. It didn’twant any short-sellers still solvent when the market finally went down. Now,the market and business are subjects of public contempt.The passing of the 1990s’ ebullience has left a vacuum. Viktor Franklsaid, “Unlike an animal, man is not told by drives and instincts what he mustdo. And in contrast to man in former times, he is no longer told by traditionsand values what he should do. Now, knowing neither what he must do norwhat he should do, he sometimes does not even know what he basicallywishes to do. Instead, he wishes to do what other people do—which is conformism—or he does what other people wish him to do—which is totalitarianism.” I fear this will not end well.
2
EARNINGSPROPAGANDA
The poor bastard didn’t even know that 10 percent ofthe net was 10 percent of nothing.—Mario Puzo, The Last Don 1
L
et’s start at the very beginning. The one thing that everyone, from themost uninformed layperson to the most erudite professor, knows aboutthe stock market is that earnings determine returns. Chapter 1 of every finance textbook, Lecture 1 of every Investment 101 class, and every news dispatch all agree:• Earnings and the market move up and down together.• The greater the earnings increases, the higher the market’s return.• When earnings are up, it is time to buy stocks, and when earnings aredown, it is time to sell.• When the market’s price/earnings (P/E) ratio is high, it is time to sell.Each of these axioms is false. As you’ll see, each is completely opposite tothe actual empirical relations. Almost everything investors are taught about43
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Practical Speculation
the relation between earnings and stock market returns, whether inbusiness schools or on the stock market pages of newspapers, iswrong.Why do people so readily embrace these fallacies?Like all propaganda, they have an appealing, superficial plausibility. The interests of those who promote propaganda are always diametrically opposed to those of the propaganda’s targets. Whatbetter way to maintain the propagandist’s power and profits than to encourage investors to buy and sell stocks in ways that further shift the wealth to thepropagandists?It is true that professionals value stocks based on a discounted stream ofearnings, cash flows, and dividends. But that is one of those maxims, such as“Never be disrespectful to authority,” that contains enough misinformation tocause abundant harm if the investor follows it to the letter without considering the rest of the picture.Stock moves from one day to the next are primarily related to transientfactors and random changes. In short-term periods, the market tends to godown after several days of excessive optimism, and it tends to go up after asimilar run of excessive pessimism. Attributing these swings in optimismand pessimism to earnings would be incorrect. It would also be dysfunctional,because no matter whether news reports say stocks are going up on earningsoptimism or down on earnings pessimism, these assertions amount to nothing more than an invitation to trade—and to trade the wrong way. If the public were to realize this, however, it might also figure out that its interestswould be better served by less frequent trading—and that would mean lesspower and fewer perks for the more successful and powerful players.In addition to maintaining Wall Street in its accustomed comfort, theearnings-returns fallacy gives an opening to other classes of players with different incentives: those who have no truck with American enterprise and markets. A poor earnings report always brings out the chronic pessimists, whoseem to relish the idea that business stinks and that stocks will fall. It givesthem one more off-the-wall reason that the American economy has been, is,or will be much worse than it appears on the surface. A whole herd of stale financial academicians with their own money safe, though stagnant, in T-billsare always ready with flawed studies showing that when P/Es are above thelevels of the 1930s, the market is likely to fall dramatically. When P/Es gethigh and stocks by chance go down in some subsequent period, how thesescholars swell with pride.These studies, in turn, energize the value boys, who still revere BenjaminGraham even though his methods enabled him to go broke at least twice and
Chapter 2 • Earnings Propaganda
45
kept most of his followers out of the bull market of the 1980s and 1990s,when the Dow rose 14-fold. The Rea-Graham mutual fund actually put Graham’s methods into practice in 1976. Investors who put money in the fund atinception would have had two-thirds less 10 years later than if they had putthe same amount in the S&P 500, with dividends reinvested.If only stocks would be down when past, current, and future earningslook great, the sponsors and champions of these fallacies would be in ecstasy.Unfortunately for them, things never work out that way. As they wait for thatsweet spot in time, they find they miss all the great accretions in wealth, muchto their seething resentment. There is no hatred more virulent than that of oldguard members who have stood idly by watching more vigorous minds replace them in the firmament.
Fuzzy MeasuresThe truth is, there is just too much uncertainty, latitude, and fuzziness in thelevel, timing, and volatility of earnings comparisons and expectations to placeundue reliance on them. Consider this scene from Mario Puzo’s The LastDon. The studio big is talking to Ernest Vail, the gifted but naïve best-sellingauthor: “I smell a big hit. And remember—you have 10 percent of the net.You have a natural flair. You can get rich on this picture, especially if it winsthe Academy.” (Previously the big had told Claudia, the heroine, that thescript was “a piece of.”)Claudia, like a select few investors, and now the readers of this book,knew better. She “could see Vail swallow the hook. The poor bastard didn’teven know that 10 percent of the net was 10 percent of nothing.”The catch to getting a percentage of net was highlighted by a 1989 articlein Los Angeles Lawyer.2 The authors, Steven Sills and Ivan Alexrod, wrote thatfewer than 5 percent of films showed a profit for “net participation purposes.” In just one example, the 1994 film Forrest Gump was one of the mostsuccessful movies of all time, grossing some $650 million. Winston Groom,the author, had a contract to receive 3 percent of net profits. But like ErnestVail and the many investors who have watched with amazement as the valueof their shares vanishes along with corporate earnings, Groom was astonished to find Paramount reporting a $60 million loss on the movie. Paramount had charged a 32 percent commission on Forrest Gump “to cover costsof future films that might fail.” (The film’s star, Tom Hanks, more experienced in the ways of Hollywood and perhaps benefiting from better legal advice, negotiated a share of the gross. As for Groom, he settled his lawsuit
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Practical Speculation
against Paramount for a promise of a share of the gross in a Gump sequelthat never materialized.)Vail and Groom both learned the hard way about the all-too-ephemeralnature of earnings. Unfortunately, financial life and death often hang in thebalance.
Testing the BeliefsShrewd articles know that they will not get far in life by relying on conventional explanations of market moves. But the great majority of investors aredeceived on both the big and the small aspects of this relation.To ensure that our readers do not fall prey to the deceptions,we tested each one of the commonly held beliefs enumeratedearlier.First, it is necessary to examine the actual relations between earnings andmarket returns. There are many different leads, lags, and ratios to be tested.The best way to reveal these relationships is with a scatter diagram, as discussed in Chapter 8. If these data tend to lie close to the line of best fit, thenthere is a strong relation. If the data appear to lie in a shapeless mass aroundthe line, there is little or no relation. Each of the charts uses earnings datafrom the Standard & Poor’s Securities Price Index Record for 2001, updatedwith current figures, and returns data from the London Business School’scomprehensive database of global markets, discussed in detail in Chapter 9.We start with the relations in the same year. Stocks are supposed to godown when earnings are down and go up with earnings are up. But theydon’t. In fact, the opposite relation holds:1. If reported S&P 500 earnings rise in a year, the S&P 500 is likely to perform worse than average that year.2. If reported earnings fall in a year, the S&P 500 is likely to perform better than average that year.The inverse relation is shown in Figure 2.1. Notice how the line of best fitslopes gently from the northwest quadrant to the southeast. This is the hallmark of what statisticians call a negative correlation. When earnings are down,there are many more occasions when stocks are up than when stocks aredown. (Unless otherwise noted, both the y variable and the x variable—the dependent and independent, respectively—will be measured as percentagechanges throughout this book.)Earnings declined in 22 of the 65 years studied. The average return for theS&P 500 during each of those down years was up 14.2 percent. This compares
% Change in Next Year’s S&P 500 Index
Chapter 2 • Earnings Propaganda
47
0.50.40.30.20.10.0–0.1–0.2–0.3–0.5
0.0% Change in Current Year’s Earnings
0.5
y = 9.6% – 1⁄5 (x)R2 = 0.5%
Figure 2.1 Change in Current Year’s Earnings as Predictor of Change inNext Year’s SPX, 1937–2001. Source: Standard & Poor’s Security PriceIndex Record.
with an average annual return of 4.9 percent in the other 43 years, when earnings increased.We used regression analysis to calculate an equation that expresses thisslightly inverse relation between earnings and the next year’s market returnas a line of best fit: S&P 500 return = 9.6 percent minus one-fifth of the annual percentage change in S&P earnings.9.6% − 1/5 (S&P 500 ∆)For example, say S&P 500 earnings rose 22 percent in a year. Pluggingthat number into our formula gives 9.6 percent − 1/5 (22 percent), or a predicted rise of 5.2 percent for the S&P 500. (Bear in mind that the upward driftin the market averages 9.6 percent a year, so a 5.2 percent gain would be subpar.) If S&P earnings fell 22 percent in a year, we would expect the S&P to return 9.6 percent − 1/5 (−22 percent), or 14 percent.The equation explains some 5 percent of the total variation in stock pricesfrom normal. Another way of saying this is that if a person knew nothingabout earnings change in a year, the best forecast of S&P 500 returns in 2002would be 9.6 percent—the average drift per year. That forecast would have awide margin of error, which would be reduced by 0.5 percent by using the
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Practical Speculation
earnings formula. A reduction at least as large as that would occur a mere 7 in100 times through chance variations alone.Given that earnings and S&P 500 returns are inversely related during ayear, then, the question arises whether relations based on quarterly numbersare predictive. No. The same inverse relation holds. The scatter diagram ofquarterly percentage changes in earnings versus the next quarter’s S&P 500return shows this. Again, the dots cluster in the northwest and southeast partsof the graph, indicating a negative correlation.If earnings rise in a quarter, the S&P 500 is likely to perform below average in the next quarter. If earnings fall in a quarter, the S&P 500 is likely tooutperform in the next quarter, as shown in Figure 2.2.Using the data for the 65-year period, during which time the trend ofquarterly S&P 500 returns was 2.5 percent a quarter, we worked out a regression formula that roughly predicts S&P 500 returns based on earningschanges. The best formula for predicting the expected change in the S&Pindex from one quarter to the next is:Expected S&P return2.5% less 1/16 of the year-over- year= percent change in S&P quarterly earningsin next quarter
Next Quarter S&P 500 Index% Change over Current Quarter
0.40.30.20.10.0–0.1–0.2–0.3
–0.5
0.00.51.0Current Quarter’s YOY Earnings Change (%)y = 2.5% – 1⁄16 (x)R2 = 3%
Figure 2.2 Change in Current Quarter’s Earnings as Predictor of Changein Next Year’s SPX, 1937–2001. Source: Standard & Poor’s Security PriceIndex Record.
Chapter 2 • Earnings Propaganda
49
This predictive relation explains 1 percent of the total variation in S&P500 Index prices. Because this calculation is based on 258 quarters, comparedwith the 40 observations that went into the yearly relation reported previously,the chances that this one is due to chance alone are less than 1 in 200.While we were examining earnings and returns data up, down, and upside in search of relations, we discovered an unexpected predictive link (seeFigure 2.3). It is an old saw in the market that stocks have predicted nine ofthe last five recessions. But as we analyzed all the possible relations betweenearnings and market returns, we discovered that S&P returns in one quarteranticipate profit changes in the next. The relation here is:Next quarter’s earnings change = 2% plus 1/3 of the previousquarter’s stock return
Next Quarter’s Earnings Change
The preceding formula explains 3 percent of the variations in earningschanges, and this is a highly statistically significant result for the 258 quartersconsidered. The relation, of course, is good for predicting earnings, not returns.We ran our conclusions by one of our readers, Bill Egan, a PhD whosespecialty is a rare combination of analytical chemistry and applied statistics.Not only that, he is married to a psychometrician, so statistical acumen runsin the family. The Egans ran some calculations of their own on independent
1.0
0.5
0.0
–0.3
–0.2–0.10.00.10.20.3Current Quarter’s Change in S&P 500
0.4
y = 2% + 1⁄3 (x)R2 = 3%
Figure 2.3 S&P 500 Predicts Earnings: Current Quarter’s Change in S&P500 as Predictor of Change in Next Year’s Earnings. Source: NiederhofferInvestments.
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Practical Speculation
data sets that verified our conclusions. Using weekly data from 1962 to 1994,the Egans also found that the return in the S&P 500 is good at predicting future earnings but that earnings moves themselves are inversely related to future S&P 500 changes.These regression equations do not explain past variations in stock returns; they merely account for a portion. But this knowledge, scant as it is, isbetter than being buffeted by the financial media like a tumbleweed in thewind, and far better indeed than to end up like the unprofitable scriptwriterErnest Vail because you have tied your fortunes directly to “net.”
Irrational RatiosThe P/E-return relation follows like a carriage behind a horse from the earnings-return relation. Low P/Es, in the popular mind, tend to be associatedwith good returns and high P/Es with bad returns. That idea figured prominently in the famous “irrational exuberance” speech of Fed Chairman AlanGreenspan on December 5, 1996. Yale University Professor RobertShiller had used the phrase irrational exuberance when he presenteda P/E study to Greenspan at the Fed the day before. Shiller, in his2000 book Irrational Exuberance, makes the case that high P/Es areassociated with inferior performance over the next 10 years and low P/Es areassociated with good performance over the next 10 years. He uses 10-year averages of P/Es and 10-year forward returns to derive his conclusions. Becauseof the high degree of overlap, one might reason that there are not enough observations in a statistical or practical sense to come to any conclusions with areasonable degree of confidence. After all, in 100 years, there are only 10 independent 10-year periods, and certainly the last 30 years (in which there arethree independent nonoverlapping 10-year periods) might be assumed to bemore important than the previous 70.Professor Shiller told us at a luncheon interview that what actuallyprompted the chairman to cross the long-standing line that had prevented theFed from fighting stock market battles was a calculated query that he hadposed to Greenspan at lunch: “When was the last time a Fed chairman actually commented that he thought the level of stock prices might be too high?”Counting out the actual relation between broad-market P/E and subsequent stock performance is not as easy a task as it might seem. In March2002, the price-earnings ratio of the S&P 500 was 29, according to Standard& Poor’s; or 40, according to Barron’s; or 