August 27, 1998
The Task at Hand

Inflation and Market Moves
By Randy Befumo
(From the 12/17/96 Evening News)

POINT: Think About the Long-Term, Not Today's Noise

Not to parrot a certain Federal Reserve Chairman, but when do we know whether or not financial assets are overvalued? Single-factor models abound that seek to link the relative value of the market to the average dividend yield, price/earnings or price/sales ratios of various indices as well as the above mentioned metrics, but the simple fact is that none of these single factor models are perfect. The valuation of equities is a machine with a heck of a lot of moving parts. Underlying inflation and growth, relative guaranteed yields from Treasury bonds, the current price and direction of commodities, and the perceived risk of systematic shocks to the delicate economic structure all need to be considered before making a call.

One of the core tenets of Foolishness is that the market is absolutely impossible to call and that attempting to do so only results in humiliation. Far too many single-factor theorists have been trotted out to prance in front of the media over the past few decades without any accountability. The more sophisticated theorists who attempt to build more complicated models end up useless to the media outlets -- these folks by and large talk about a number of potential outcomes without fixating on the most extreme, constantly emphasizing the degree that remains uncertain. The net result is that individual investors trying to make investment decisions end up frozen without any credible source articulating a viable strategy that seems to assuage their legitimate concerns about their savings.

The first thing that people need to understand is that unlike commodities or options, the stock market is not a zero sum game. The total aggregate value of the wealth that the market has created since its inception in its current form in the 19th century is absolutely staggering. Through boom and bust, the return on equities relative to the returns of every other possible financial assets is laughable. Jeremy Siegel's Stocks for the Long Run looks at the value of a dollar invested in various types of financial assets in 1800 and then calculates where you would have stood in 1992 had you followed the much vilified buy-and-hold strategy. (A strategy I tried to defend in The Buy And Hold Apocalypse? this summer when many were announcing the beginning of a new "bear" market.)

--- $1 in 1800 dollars is equivalent to $11.80 in 1992 dollars due to inflation.
--- $1 in 1800 dollars became worth $13.40 in 1992 dollars if you put it in gold, the asset everyone amazingly flees to when stuff gets rough, barely beating inflation.
--- $1 in 1800 dollars became worth $2,934 in 1992 dollars if you put it in Treasury Bills, a short-duration form of bond.
--- $1 in 1800 dollars became worth $6,620 in 1992 dollars if you put it in Treasury Bonds, your average bond.
--- $1 in 1800 dollars became worth $3,050,000 in 1992 dollars if you put it in blue chip stocks.

Are people afraid of stocks because they are guaranteed to underperform? No. In fact, if you read the Buy and Hold Apocalypse?, you will see that over periods of 15 years or more your odds of outperforming any other financial asset class by investing in stocks is extremely high. This chance of outperforming grows until you are 30 years out, at which point you hit a 99% chance, the highest degree of certainty that any form of statistical analysis can provide. The thing is that other assets that are not as volatile seem safer, even though the risk of underperforming stocks over significant periods of time is very high.

For some reason, risk has been equated with volatility and not with the possibility of underperformance over long periods of time. The way that risk has been defined by the financial community drives the individual investor's decision process in a profound way, causing them to dally with things like precious metals in spite of the fact that they have been dismal performers for two centuries. Sure, gold had a hey-day in the '70s... but then again, so did leisure suits. The original Motley Fool Investment Primer, that imperfect work that appeared years before the book that many are now familiar with, said something that I have long considered to border on profound: "The least-mentioned, biggest risk of all is not taking enough risk." It is kinda like dating -- the only sure way to not go out with someone is never to ask them out to begin with.

Prognostication, as imperfect as it is, is something everyone dabbles with. Is the market as a whole going up or down? Frankly, who really knows? What is possible for the individual investor is to identify good businesses with strong financial characteristics (not simply great stories) and commit to them for long periods of time unless their value becomes so exaggerated relative to their potential that one has better prospects elsewhere. This methodology escapes the silliness of single factor models, the instability of multi-factor models, and the round-and-round exhaustion most investors put themselves through, chasing their own tails by desperately trying to predict the next "bear" market -- something that boggles even the most practiced professionals. Do what is within your purview, accept uncertainty and take comfort in odds significantly in your favor over long periods of time.