The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [36]
The Higher they Go, the Harder they Fall
As the enduring antidote to this kind of bull-market baloney, Graham urges the intelligent investor to ask some simple, skeptical questions. Why should the future returns of stocks always be the same as their past returns? When every investor comes to believe that stocks are guaranteed to make money in the long run, won’t the market end up being wildly overpriced? And once that happens, how can future returns possibly be high?
Graham’s answers, as always, are rooted in logic and common sense. The value of any investment is, and always must be, a function of the price you pay for it. By the late 1990s, inflation was withering away, corporate profits appeared to be booming, and most of the world was at peace. But that did not mean—nor could it ever mean—that stocks were worth buying at any price. Since the profits that companies can earn are finite, the price that investors should be willing to pay for stocks must also be finite.
Think of it this way: Michael Jordan may well have been the greatest basketball player of all time, and he pulled fans into Chicago Stadium like a giant electromagnet. The Chicago Bulls got a bargain by paying Jordan up to $34 million a year to bounce a big leather ball around a wooden floor. But that does not mean the Bulls would have been justified paying him $340 million, or $3.4 billion, or $34 billion, per season.
The Limits of Optimism
Focusing on the market’s recent returns when they have been rosy, warns Graham, will lead to “a quite illogical and dangerous conclusion that equally marvelous results could be expected for common stocks in the future.” From 1995 through 1999, as the market rose by at least 20% each year—a surge unprecedented in American history—stock buyers became ever more optimistic:
In mid-1998, investors surveyed by the Gallup Organization for the PaineWebber brokerage firm expected their portfolios to earn an average of roughly 13% over the year to come. By early 2000, their average expected return had jumped to more than 18%.
“Sophisticated professionals” were just as bullish, jacking up their own assumptions of future returns. In 2001, for instance, SBC Communications raised the projected return on its pension plan from 8.5% to 9.5%. By 2002, the average assumed rate of return on the pension plans of companies in the Standard & Poor’s 500-stock index had swollen to a record-high 9.2%.
A quick follow-up shows the awful aftermath of excess enthusiasm:
Gallup found in 2001 and 2002 that the average expectation of one-year returns on stocks had slumped to 7%—even though investors could now buy at prices nearly 50% lower than in 2000.2
Those gung-ho assumptions about the returns on their pension plans will cost the companies in the S & P 500 a bare minimum of $32 billion between 2002 and 2004, according to recent Wall Street estimates.
Even though investors all know they’re supposed to buy low and sell high, in practice they often end up getting it backwards. Graham’s warning in this chapter is simple: “By the rule of opposites,” the more enthusiastic investors become about the stock market in the long run, the more certain they are to be proved wrong in the short run. On March 24, 2000, the total value of the U.S. stock market peaked at $14.75 trillion. By October 9, 2002, just 30 months later, the total U.S. stock market was worth $7.34 trillion, or 50.2% less—a loss of $7.41 trillion. Meanwhile, many market pundits turned sourly bearish, predicting flat or even negative market returns for years—even decades—to come.
At this point, Graham would ask one simple question: Considering how calamitously wrong the “experts” were the last time they agreed