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Can professionals time the market any better than Alan Green-span? “I see no reason not to think the majority of the decline is behind us,” declared Kate Leary Lee, president of the market-timing firm of R. M. Leary & Co., on December 3, 2001. “This is when you want to be in the market,” she added, predicting that stocks “look good” for the first quarter of 2002.3 Over the next three months, stocks earned a measly 0.28% return, underperforming cash by 1.5 percentage points.

Leary is not alone. A study by two finance professors at Duke University found that if you had followed the recommendations of the best 10% of all market-timing newsletters, you would have earned a 12.6% annualized return from 1991 through 1995. But if you had ignored them and kept your money in a stock index fund, you would have earned 16.4%.4

As the Danish philosopher Søren Kierkegaard noted, life can only be understood backwards—but it must be lived forwards. Looking back, you can always see exactly when you should have bought and sold your stocks. But don’t let that fool you into thinking you can see, in real time, just when to get in and out. In the financial markets, hindsight is forever 20/20, but foresight is legally blind. And thus, for most investors, market timing is a practical and emotional impossibility.5

What Goes Up…

Like spacecraft that pick up speed as they rise into the Earth’s stratosphere, growth stocks often seem to defy gravity. Let’s look at the trajectories of three of the hottest growth stocks of the 1990s: General Electric, Home Depot, and Sun Microsystems. (See Figure 7-1.)

In every year from 1995 through 1999, each grew bigger and more profitable. Revenues doubled at Sun and more than doubled at Home Depot. According to Value Line, GE’s revenues grew 29%; its earnings rose 65%. At Home Depot and Sun, earnings per share roughly tripled.

But something else was happening—and it wouldn’t have surprised Graham one bit. The faster these companies grew, the more expensive their stocks became. And when stocks grow faster than companies, investors always end up sorry. As Figure 7-2 shows:

A great company is not a great investment if you pay too much for the stock.

The more a stock has gone up, the more it seems likely to keep going up. But that instinctive belief is flatly contradicted by a fundamental law of financial physics: The bigger they get, the slower they grow. A $1-billion company can double its sales fairly easily; but where can a $50-billion company turn to find another $50 billion in business?

Growth stocks are worth buying when their prices are reasonable, but when their price/earnings ratios go much above 25 or 30 the odds get ugly:

Journalist Carol Loomis found that, from 1960 through 1999, only eight of the largest 150 companies on the Fortune 500 list managed to raise their earnings by an annual average of at least 15% for two decades.6

Looking at five decades of data, the research firm of Sanford C. Bernstein & Co. showed that only 10% of large U.S. companies had increased their earnings by 20% for at least five consecutive years; only 3% had grown by 20% for at least 10 years straight; and not a single one had done it for 15 years in a row.7

An academic study of thousands of U.S. stocks from 1951 through 1998 found that over all 10-year periods, net earnings grew by an average of 9.7% annually. But for the biggest 20% of companies, earnings grew by an annual average of just 9.3%.8

FIGURE 7-2 Look Out Below

n/a: Not applicable; Sun had net loss in 2002.

Sources: www.morningstar.com, yahoo.marketguide.com

Even many corporate leaders fail to understand these odds (see sidebar on p. 184). The intelligent investor, however, gets interested in big growth stocks not when they are at their most popular—but when something goes wrong. In July 2002, Johnson & Johnson announced that Federal regulators were investigating accusations of false record keeping at one of its drug factories, and