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Education, analysis, and advice for uncertain times



by William Fox, Oct 1, 2003


In the 1980’s and 1990’s one saw endless studies, such as a famous 75 year study by Ibbotson Associates, claiming that the long term inflation-adjusted percentage average annual rate of return for bonds was supposed to be around 2-3%. The rate of return for stocks is supposed to be another 5% on top of that, providing a total return of 7%. Brokerage firms jumped all over this data during the great bull market from 1982 to 2000, insinuating to their brokers and their clients that investing is easy. It seemed like every other broker’s office had a big multicolored Ibbotson chart hanging on its wall to help make this case. The pitch was, “Just open up an account, add some assets, diversify a bit, ride ride out short term volatility, hold for the long term, and these kinds of returns will very likely take place.”

In my video section I have included the Saturday Night Live parody of a commercial that came out in 2002 where Charles Schwab advised a group of investors to just relax and stay diversified with different types of stock and bond positions. (Beyond that particular spoof, I believe it may be unfair to compare Schwab and Co.with the character of the fictitious Saturday Night Live firm “Global Century”). During the 1990’s, the extra volatility of stocks was not scaring investors into maintaining some kind of 5% “risk premium” over bonds, in fact, to the contrary, as the market bubble grew larger and became increasingly more volatile, risk premium considerations were increasingly ignored. This was a complete decoupling from reality, because increased volatility is typically associated with higher risk in finance theory. The number of American households invested in the market climbed from a low of 25% in the 1970’s to nearly 75% near its 2000 peak. Most 401K and pension fund advisors kept advising Baby Boomers to maintain the same asset allocations of stocks and bonds and keep investing the same proportion of their paychecks right up to the very peak of the market in March 2000 and beyond.

Needless to day, the bear market losses since 2000 have helped to undermine public confidence in the 1982-2000 bull market buy anywhere-and-hold-forever arguments. Academic and private research consultants are also showing more doubts. One example is the July 13, 2003 (UK) Observer article by David Schwartz: “Revealed: The Great Stock Market Swindle,” which states that “During the 1800s, the UK stock market grew at a miserly average annual rate of 0.6 per cent after factoring out the effects of inflation. By recent standards, investment profits of this magnitude were pretty dismal.” As another example, in the July 22, 2002 Forbes article by Daniel Fisher, “The Great Stock Illusion,” he states, “…Including dividends and discounting for inflation, the [long-run historical stock] return over the past two centuries has averaged 7% a year. Early-19th-century data are a little sketchy, but such a conclusion about the long-term performance of stocks is well accepted…[analysts] Arnott and Bernstein deconstructed the 7% return. A large part of it--close to 5%--came from dividend yields; a smaller portion, 1.4%, from earnings growth. A remaining sliver came from an expansion in price/earnings multiples. Note that we're talking averages here, and there was much variation in the components over time. In early years dividends were fat while P/E multiples didn't go anywhere. In the 1982-99 bull market, in contrast, yields collapsed but stock market investors more than made up what they lacked in dividends with a wild expansion of P/E multiples.”

Who has it right here – the buy and hold crowd or the market debunkers? On this issue, I think the “Austrian” school (the same folks I also mention in my “Learning the score” section) can be helpful, where we approach the issue from a free market supply and demand viewpoint much like we would if we were contemplating opening up a small business, such as a gas station on a street corner or card shop in local shopping mall.

What if I were to tell you, “If you open up a gift shop on a local shopping mall, you should clear on average at least a 7% a year return on capital.” Your response would probably be, “That is too simplistic. To make a sound business decision, I need to consider a wide variety of factors in depth. As some examples, I need to analyze economic fundamentals to include supply and demand factors, assess the competition, create a mental time line of expected inputs and outputs of capital, and find areas where I have the best sustainable competitive advantage and highest chance of risk adjusted returns. It is ridiculous to suggest that simply by drumming up enough money to start a gift shop business in a local shopping mall I can expect any particular rate of return, such as 7%”

Exactly. Welcome to the competitive free enterprise system. In such a system, no particular type of business or investment approach can expect an endless “excess return” just for opening its doors or “getting in,” unless it is the recipient of some kind of special advantage conferred by a de facto private cartel or special privilege enforced by the government. As soon as excess returns become evident, competition typically comes in and tries to erode the returns away. There is nothing wrong with sustaining a competitive advantage through attention to detail, continued focus on meeting customer needs, superior organization, cost-cutting, and other factors, but in a free enterprise system sustaining an advantage is not supposed to be forever easy. When it gets too easy, usually something crooked is going on.

Investing in stocks and bonds is no different than any other kind of business, to include investing in real estate or opening up your own retail store. If one does not pay attention to supply and demand factors and other business realities, one can lose ones shirt in any of these areas even more easily than one can make money through dumb luck.

I do not think that it is absurd to apply microeconomic principals on a macroeconomic, national level. In the long run, stock and real estate investments are nothing more than way to participate in the underlying growth and vitality of an underlying economic base. As an example, imagine you invest in mining town in the middle of Nevada that is solely dependent on a local mine whose sole operation is in the area. You own shares in the mining company, the supply company that runs the local hardware and grocery store, and also own parcels of real estate on main street that collect rents from the local hotel, saloon, and bank. If more rich veins are discovered, more mining activity and money will be attracted to the area, and ones portfolio of stock and real estate investments for that area is likely to appreciate. If the veins run out and leaves a ghost town, the value of ones portfolio of stocks and real estate would likely drop towards zero.

Imagine that America were to show demographic, institutional, and economic performance trends towards becoming a Third World country. This has already happened to Argentina, which slipped from being a First World to a Third World country in the 20th century. If this were to happen, one could easily bet that the equivalent of Ibbotson Associates data for the next seventyfive years will show a negative average annual real rate of return after inflation. How many stockbrokers do you believe would post a chart showing that kind of trend on their office walls?

Another important point needs to be made here regarding applying “Austrian” principles to macroeconomics. Free enterprise can be brutal, but at least it provides more honest economic feedback for efficiently managing and growing an economic system. In contrast, forms of government intervention may appear “kind” up front (transfer payments, make work programs, and subsidies to alleviate unemployment, poverty, and inadequate housing) but it distorts the economy, clouds economic pricing mechanisms, politicizes economic data, is less efficient, and tends to run down the economic resource base over the long run, typically causing far more duress over the long run and on the back end compared to laissez faire capitalism. Free enterprise tends to be more brutal up front, but is more efficient and productive over the long run. With government involvement and intervention, it is the other way around.

One of the major points of my investment outlook (c.f. my “Bear Case Overview” and “Amidst Bullish Hoopla” papers) is that economic feedback mechanisms have become so politicized and distorted in America that most Americans do not realize the seriousness of America’s current economic situation. The fact that applying “Austrian” microeconomic principles on a macroeconomic level might shock many Americans may be an indication of the way in which we have been propagandized a nexus of Big Government, Big Central Bank (Federal Reserve Banking System), and big NYC-based national media in the 20th century.


According to columnist Ken Fisher in a Forbes article that came out a couple of years ago, a number of studies show that all of the different stock market sectors (such as technology, health care, and financial services) tend to have an approximately equal rate of return over a very long period of time, one reason being that the quantity of underlying shares of stock are also subjected to the laws of supply and demand. When a sector gets hot, investment banks start bringing more new companies public within that sector and other companies in that sector start making more secondary offerings to raise cheap capital. More incompetent managers can enter the industry and wing it on hype, and more banks issue marginal loans. This trend typically increases to the point that the amount of stock within that sector gets diluted and begins to drive down excess returns. Valuation measures such as net asset value, cash flow, and earnings per share steadily drop, reducing the valuation "cushion" beneath stock prices and encouraging their fall over the long run. In depressed industries, the opposite trend tends to take place. The supply of total stock gets tightened up from share buy-backs, mergers and acquisitions, and bankruptcies. Incompetent managers get fired and bad debt gets liquidated and cleansed from the system. Valuation measures such as net asset value, cash flow, and earnings per share (to include intangible "quality of earnings") start to rise and drive share prices higher.

In regard to very highly competitive sectors such as technology, Forbes columnist and publisher Rich Karlgaard has pointed out that only about 20% of the technology leaders in one decade have remained leaders in the following decade. Lastly, in regard to investment strategies, Victor Niederhoffer pointed out in an interview with James Puplava that as soon as a particular approach to investing begins to show consistent success, investors tend to pile in, drive up prices, and drive down the potential long term rates of return. In the long run, once again, nothing is guaranteed or a sure thing. There is no guaranteed long term “excess return” or “free lunch” in a competitive, free market economy.


No matter how dismal things become in one area, there are always other areas that can make money. As an example, precious metals and other commodities-related areas have been in a bull market since 2000. Certain foreign bond funds have made money as the dollar began its slide in 2001. Certain inverse interest rate funds may have started to form a bottom since the beginning of summer 2003. All of these areas are negatively correlated with the overall stock market. If Neil Weinberg's article "Here We Go Again: Think this stock rally is different? So did the Japanese,” in Forbes Magazine, July 7, 2003, page 52, proves correct, all of the aforementioned contrarian areas could remain promising. . Weinberg superimposed a graph of the S&P 500 from 1994 to mid 2003 over a graph of the Nikkei from 1984 to 1993 to show an uncanny resemblence. He also shows the continued downward performance of the Nikkei from 1993 up until mid 2003.

If interest rates and inflation start heading back up, which I believe is very likely (c.f. my “Amidst Bullish Hoopla” article), then that will likely hurt the market resale value of domestic bonds and erode the purchasing power of domestic CDs. A 1% rise in interest rates from 5% to 6% on a 30-year bond hurts its resale value by 13.8%. A rise in interest rates into double digit territory, reminiscent of the stagflationary 1970s, would not only likely pulverize the bond market, but also knock the stock market down to single digit P/E multiples. As of Aug 2003 the S&P 500 traded at over 30 times earnings.

For more aggressive investors who are comfortable with the “psychological pain arbitrage” concept I describe in the third paragraph of my “Learning the score” section, there are many other types of investments that we can discuss. I believe that the dollar is likely to continue sliding over the long run, and that the secular bear market has much further to go.




Flag carried by the 3rd Maryland Regiment at the Battle of Cowpens, S. Carolina, 1781

© Text and web design by William Fox. Sometimes William Fox offers viewpoints that are not necessarily his own to provide additional perspectives.