The Power of Conventional Wisdom

The week between Christmas and New Year’s is probably a good time to throw out half-baked ideas on topics I don’t know much about.

First, there’s been a lot of talk about the “lost decade” for stocks. The S&P 500 is below where it was a decade ago. Dividend yields bring you back up to break-even (the Vanguard Total Stock Market Index Fund had average annual returns of 0.18% for the ten years through the end of November, and that’s after about 0.1% in expenses), but inflation sets you back a couple of percentage points per year. (Vanguard’s S&P 500 index fund, however, was negative over those ten years.) James Hamilton, drawing on data from Robert Shiller, has some thoughts on why the stock market did badly; the fundamentals were so-so, but the big factor was that valuations were at their historical peak at the beginning of the decade.

For me, the worrying thing about investing in stocks is not specifically the high price-earnings ratio. It’s the fact that in the 1990s, everyone started saying that stocks were the best long-term investment, because “over any thirty-year period ever stocks do better than any other asset class.” That’s not a direct quote, but I’m sure you can find hundreds that are virtually the same. There are two problems with this statement. The first is that it’s assuming the future will be like the past. But the bigger problem is this: if everyone thinks that X is the best long-term investment, then it probably isn’t, in part because enthusiasm about X will drive the price of it up. I believe people were saying roughly the opposite in the late 1970s, and look what happened in the next twenty years.

That said, I’m no investment genius, and I have a fair proportion of my money in equity index or near-index funds. But the general point is that when everyone agrees on an investment strategy, they are probably wrong.*

Second, there’s been a lot of China boosterism in the past year or so, as the Chinese economy has returned to growth and its stock market has soared. The Times had an article today on the topic. I’m far from an expert here, but wasn’t the government basically ordering state-owned banks to  lend money cheaply and without asking too many questions? Aren’t Chinese economic statistics so bad that economists use electricity consumption as a proxy for GDP? Haven’t we seen this movie before all over emerging markets around the world?

I think some of the U.S. press coverage of China reflects our pessimism about ourselves; in that sense, it reminds me of the idolization of Japan that took place in the 1980s. Of course, there are huge differences. The Chinese economy has nowhere to go but up, and with over 1.3 billion people its economy will surpass ours in gross output in my lifetime. (On a per capita basis, though, I don’t think that will happen in my daughter’s lifetime, even if there is a Chinese immersion charter school down the road here in Western Massachusetts.) But just as the United States is not on the brink of world-historical disaster, so everything is not perfect in China.

* What’s the right grammar here? I know “everyone” is singular, but are you really supposed to say “when everybody agrees on an investment strategy, he is probably wrong”?

By James Kwak

35 responses to “The Power of Conventional Wisdom

  1. * What’s the right grammar here? I know “everyone” is singular, but are you really supposed to say “when everybody agrees on an investment strategy, he is probably wrong”?

    I agree, it is a very minor issue, but how about: When ALL agree on an investment strategy, they are probably wrong.

  2. In reference to the asterisk—
    I think it sounds ok to the ear, so it doesn’t matter. You might have ended the sentence “……., then that investment strategy is probably wrong.”

  3. Most of the “experts” on China, including those writing books and giving seminars, don’t know shit about China. EVERYTHING is still centrally controlled. And many of the government statistics are made-up just to make targets. Mayors fabricate numbers and all the way up to provincial governors fabricate numbers. You don’t make targets, you lose your cushy government job, so guess what??? You ALWAYS make your government target. Please excuse the 10 second commercial at the start. Here’s your Chinese free market economy. From Al Jazeera TV.

  4. Partly the last decade has been about a return to the mean of stock market growth values. Recall that the 80s and 90s posted annual growth rates of 15% whereas the average from 1871 to 2008 was 8.5%. Clearly rising so high above the mean meant that values had to fall/stagnate to get back to the mean value. Yes the past is not necessarily a view of the future, but it is one of the better views we have. Otherwise one could read tea leaves to predict the future.

  5. Michael Pettis of the China Financial Markets blog (the most knowledgeable expert I read on the subject) frequently compares China in this decade to Japan in the 1980s, for sentiment and other reasons. He’s well worth a read.

    I’m not sure I agree with the statement that the Chinese economy has “nowhere to go but up.” They’re the 3rd-largest economy on the planet, and the largest Statist economy of all time. There’s plenty of downside there.

  6. “What’s the right grammar here? I know “everyone” is singular, but are you really supposed to say “when everybody agrees on an investment strategy, he is probably wrong”?”

    I would say, “when everybody agrees on an investment strategy, the consensus is probably wrong”

  7. China presents an interesting case, especially since there is no historical data to assess the situation.

    The problem is with the claim that free market capitalism is inherently superior to command economies. Although China permits markets, it is a command economy and most of the largest companies are state-owned or controlled. If the claim is that China will surpass the US soon (Niall Ferguson), does that invalidate the claim that capitalism is the superior system? Seems so.

    Something’s got to give here. Either the US is headed for a command economy, or China’s command economy is built on sand (or else there will be a capitalist revolution in China)

  8. “But just as the United States is not on the brink of world-historical disaster”

    Qualify this please. It feels good to say and hear that we’re not, but can we have at least a bulleted list of 10 reasons with which to convince ourselves?

  9. I would use “they” instead of “he”, not to avoid using the singular pronoun for “everybody”, which I think is good usage, but rather to avoid the gender-specific “he”.

    There is some grey around all this. Most people in the US use the plural form of a verb when “none” is the subject. But it’s a contraction of “no one” so I use the singular with it. I think most English people do also.

    As for stocks as a long-term investment, they are merely a call on future production, so the return on stocks ultimately will be a function of just a few stable or predictable variables:

    1. GDP growth

    2. Corp profits as a % of GDP

    3. Demographic supply and demand for stocks, measured in a simple way such as changes in the ratio of retirees to active workers.

    It is possible to look at long-term historical series for the first 2, providing some guidance for the future; and at the past, and a range of future projections for the 3rd.

    It doesn’t look good for US stocks.

  10. Sounds just like corporate America. You don’t make your numbers you lose your job – so you get quite creative about making your numbers.

  11. The Baseline Scenario site, seems to be very articulate, and nice, in the way they post news, etc. I have to say you’re too nice, and too naive. If you want real news, data to help you plan your future, in the decaying US, read these sites: http://www.zerohedge.com/ and http://www.kunstler.com/index.php

  12. China, another bogus economy!

  13. The problem with conventional wisdom is that it’s not really wise, just conventional. There are wise people out there, but most are considered unconventional, just look at those who predicted the bubble and burst, weren’t they both wise, and at that time, unconventional? China has a fake economy, trying now to make up (by spending their saved fortune, for a real drop in our consumer spending by massively propping up their own economy (thereby proving that they can survive without us. But, that too will run its course, and then, woops, no more bullets in their guns.

    It’s high time that greed, worldwide, was replaced by prudence, and learning to be happy with less, much less, since less is the new paradigm (in business speak). We had the ball on the 1 yard line and fumbled to give away the world championship. We had it all, and then let the Congress, Whitehouse, and the greedy bastards on Wall Street wash it all away. Now, it the answer to look to China to lead the way? I don’t think so, but we definitely need much more unconventional wisdom to lead America forward. I thought that might be our newly elected President, but NOOOOOOOOOO, not apparently!!!!

  14. “when everybody agrees on an investment strategy,” it “is probably wrong.”

  15. “For me, the worrying thing about investing in stocks is not specifically the high price-earnings ratio. It’s the fact that in the 1990s, everyone started saying that stocks were the best long-term investment,”

    Don’t worry, they were saying that long before then. :)

  16. And cheer up! Now they are saying that buy-and-hold is dead. ;)

  17. When every one of them agrees on an investment strategy, every one of them is wrong.

    He is a DEFINITE it cannot have an INDEFINITE antecedent which is why it sounds wrong to match it with everyone; it is wrong.

    THEY is technically demonstrative and in any event is the wrong number.

    When everyone agrees on something, each is wrong.

    Thats what you want, to use each as the referent.

  18. “when everyone agrees… they are probably wrong” is fine. Consider the similar sentence “We told everyone they were free to leave”. Much more background, including historical examples (Shakespeare etc.) via LanguageLog, e.g. http://itre.cis.upenn.edu/~myl/languagelog/archives/002740.html

  19. “Everyone” is fine, but “everybody” is better.

  20. The link below from Reuters pretty much spells out the rules of doing business in China. Based on the fact GS is the counter-party should we cheer or jeer??? If I was ANY type of person/firm thinking about doing business in China I would think long and hard. http://www.reuters.com/article/idUSSGE5BS09T20091229?type=marketsNews

    The Chinese don’t do ANY deals they don’t get the long end of the stick on—ANY. It was another sign of Obama’s exceptionally high intelligence when he walked out of his trip to China with nothing—that was the BEST he could have hoped for.

  21. Historical stock price trends are meaningless. What has changed is the operation of public corporations. Executives now extract all the growth through options issued to themselves. What is left is volatility.

  22. maynardGkeynes

    “For me, the worrying thing about investing in stocks is not specifically the high price-earnings ratio. It’s the fact that in the 1990s, everyone started saying that stocks were the best long-term investment,”

    Don’t worry, they were saying that long before then. :)”

    They were, indeed, saying it long before then. What made the difference was the widespread adoption of 401Ks. This allowed Wall Street to make a full frontal assault on the pocketbooks of American workers by pitching this BS to an unsophisticated new audience. The 401K movement greatly intensified the marginal demand for equities, and in a sense, still does the support the market. 401K investors are a passive lot. However, recent data suggests that equity allocations in 401k portfolios are diminishing. This could lead to the phenomena playing in reverse as marginal demand withers.

  23. Goodhart’s Law:

    http://en.wikipedia.org/wiki/Goodhart's_law

    Which is why, btw, I would be exceptionally concerned about blind investing in “total market” etfs right now. It’s a subsidy to hedge funds that short sell lousy stocks as new liquidity blindly enters every security in an asset class.

    But then, this should be reflected in relative valuations, right?

  24. We used to invest in companies to try and make goods and services. Now we all try to make money. That’s the problem.

    “The love of money is the root of all evil”. Money is a tool, people. Get back to thinking of it that way.

  25. For the 40-yr period ending last spring, 20-yr Treasury bonds outperformed equities:

    http://www.indexuniverse.com/publications/journalofindexes/joi-articles/5710-bonds-why-bother.html?Itemid=11

    Think of the fees and trading costs that would have been saved if investors had simply sat on their Treasury holdings. What a sham the whole investment advisory business has proven to be.

  26. What’s the right grammar here? I know “everyone” is singular, but are you really supposed to say “when everybody agrees on an investment strategy, he is probably wrong”?

    Yes, the indefinite pronoun “everyone” is singular and it is correct to say “everyone agrees….” Technically, it would be followed by a singular pronoun: “When everybody agrees on an investment strategy, he is probably wrong”? However, usage, because it sounds odd using “he,” has morphed to accept “they” more and more commonly, especially in the U.S.

    When everyone agrees on an investment strategy, they are probably wrong.

  27. This shows that happiness is not just function of own wealth, but also comparison with others. Why some Americans still don’t understand “enough”? Still dream of high growth rate. Is US still a developing country? Past decades showed the signs of limits to growth. If capitalists are clever enough, quickly find a way to make it declines slowly (Yes, this is the bast base!); otherwise we can expect a collapse. Best wishes 2010.

  28. The problem with China, and its strength, is the problem and the strength of all centrally planned economies. Response to any situation can be swift and strong, as political and consensus considerations take a back seat to the will of the central command. The economy is stronger, more efficient, and more responsive — until the central authority is wrong. Then the results can be disastrous.

    The strength of the US has always been the 50 individual autonomous laboratories for public policy, with permission to innovate and at least some implicit guarantee against complete failure (although individual policies can certainly fail miserably). The most successful systems are replicated.

    Americans are often drawn to the efficiency offered by enforcing a federal system for some public service. But it is difficult to accept that the inefficiency of state-by-state regimes actually provides valuable diversity and resiliency in the society and the economy.

  29. James, I love your observation about the herd being necessarily wrong (unwise crowds? ;) ). I also appreciate the comment from maynardGkeynes about the impact of 401(k) accounts — and, by association, mutual funds — on driving down the value of equities.

    Another aspect of this has been bothering me for some time. The financial media has contributed to this trend/problem/advers impact (?) enormously by parroting the same message about “stocks are the only hedge against inflation long-term” — and, of course, they’re largely funded by advertising from the mutual fund and discount brokerage industries. Conflict there? It’s frustrating that these “experts” also tout “diversification” but suggest it’s somehow possible to diversify by simply buying a mix of equities (when we know that, a lot of the time, the entire market moves in one direction!).

    Americans are often criticized for not saving enough, but billions of dollars HAVE been saved in retirement accounts (I tend to think these numbers aren’t even included in the scolding analyses cited to show how terrible we are at saving) — and, the structure for these accounts has made it all but impossible for people to make thoughtful investment decisions. The “self-directed” IRAs offered at most brokerages are even worse (since they provide an illusion of control but really only offer public securities — and, of course, no company match potential).

    And don’t even get me started on 529 plans … college savings plans that “protect” consumers by restricting their investments to a few mutual funds (who lobbied hard to get the exclusives, naturally). How many parents are now in full panic mode because their college savings have been slashed in half? That story seems to have gotten almost no attention in the consumer finance media … hmmm, wonder why?

    Just like when the herd decides to all do the same “smart” thing, it becomes immediately less so, it seems that whenever the government puts in boundaries to “protect” consumers from themselves, there’s a good chance the protection will ultimately do more harm than good.

    Laurie
    ps I realize I got a little off topic here. But, thank you for letting me “share”! :)

  30. Laurie,

    I think the 401(k) and similar savings plans are included in the overall savings numbers. As to why people don’t participate, even with a corporate match, see “$100 Bills on the Sidewalk” at http://www.nber.org/programs/ag/rrc/04-08BLaibsonFinal.pdf

  31. I concur… I’d also like to hear how this all has a chance to end nicely….

  32. StatsGuy – I find your posts very spot-on… I am interested in your thoughts on what WOULD make a good investment strategy for 2010… more for capital preservation than growth… which I gather will be influenced by your thoughts on inflation vs. deflation…