Jack Bogle: How to Invest When Stock Prices Are at All-Time Highs
Well, we've all been favored with the fruition, as it turns out today, of the ancient Chinese curse: may you live in interesting times. But especially interesting they are, with stocks soaring unprecedented heights as new forces of technology and globalization permeate our world. We can't walk away from it, so deal with it we must.
Mutual funds, which know nearly 20% of all stocks today, own only, if that's the right word, three percent of Coca-Cola, six percent of Procter and Gamble, seven percent of GE, seven percent of Microsoft, and eight percent of Merck. Five of the very largest firms in the Standard Poor's index, together these five firms have a market capitalization of almost one trillion dollars out of a U.S. market of about eight trillion. These five stocks are up forty percent this year, far above the gain of 25% for the index.
It's not, it seems, the index funds are the problem, but the envious non-indexed funds, anxious unless they fall further back, are the problem. In all, speculation similarities with 1929 abound and I don't hesitate to haul up the warning flag. The worrisome signs not only include the high valuations I've described, but the similarity of the words we read today with those of the now forgotten era.
For example, a United States president who says, “No Congress ever assembled on surveying the state of the union has met with a more pleasing prospect than that which appears at the present time. In the domestic field, there is tranquility and contentment, and the highest record of years of prosperity,” Calvin Coolidge, December 8, December 4, 1928.
And a financial article states, “This is pretty smoking, pretty stinging. The establishment of mutual funds by banks and independent groups has almost become a fad. The public appetite for them grows even more rapidly than the funds can represent, buying power in the market that appears to be without a saturation point.” New levels in the stock market, August 1929.
In short, it seems to me that speculation, betting on higher and higher valuations, is in the driver's seat. Investment, betting on the fundamentals of dividend yields and earnings growth, is in the back seat, probably even in the rumble seat. But when speculation drives stock returns in the short run, while it drives stocks returns in the short run, the crystal clear lesson of history—at least the past 200 years—is that in the long run, fundamentals drive returns.
So that tension has to be resolved. Let me give you two extreme possibilities. One: a market drop of 35 percent just for the fun of it. This would lower price earnings ratio to a more normal level of about 13 times, and at 5200 in the Dow, we would still repose, I might add, fat, dumb, and happy where we sat in January 1996, just a year and one half ago. This is hardly a doomsday scenario.
Two: We’re in a new era in which stock returns average fifteen percent, fourteen percent earnings growth, and a one percent dividend yield rather than the long-term historic norm of about ten and a half percent, six and a half percent earnings growth plus a four percent dividend yield. In short, a new era of boom times and high valuations that would justify today's price levels.
Indeed, Barton Bigs, that imminent if volatile guru at Morgan Stanley, bearish as he has been for so long, famine will follow feast in the long run. He entertained this idea a few months ago in a paper entitled “A New Mean to Revert To.” He did include the question mark. At least he tranced on a new real mean return for stocks of ten percent after inflation, but finally fell back on a seven to eight percent range, much higher than the norm of about five or six percent, but not nearly enough to justify today's price levels.
The bulls' case is quite beautiful. You want to hear it? It's exemplified by a recent article in Wired magazine. I don't know how many of you read Wired, but you can get it on www.wired.com. 5.07 slash Long Boom for July 1997. It's entitled, of all things, “The Long Boom,” with the subtitle, “We're facing 25 years of prosperity, freedom, and a better environment for the whole world.”
You got a problem with that? No, I got no problem with that. Who among us could possibly have a problem with that? With watching, quote, quoting from the article, “the beginnings of a global boom on a scale never experienced before.” You entered a period, it continues, of sustained growth that could eventually double the world's economy every dozen years and bring increasing prosperity for quite literally billions of people on the planet.
That will do much to solve seemingly intractable problems like poverty and ease tensions throughout the world, all without blowing the lid off the environment. What a scenario! The thesis, you might imagine, is based on the triumph of the United States and the end of major wars. New technology, a truly global market, corporate restructuring, high economic growth, and waves of technology: a virtuous circle, the magazine calls it, driven by an open society and integrated world.
As a result, the article continues, the Fed lifts its foot off the brake. Productivity soars, biotechnology revolutionizes agriculture, alternative sources of energy abound. Europe is integrated by 2002, Russia has a solid economy by 2005, and China develops the world's largest economy by 2020. All in all, quote, “a radically optimistic meme.”
I'd never heard the word meme before and I failed to find it in the dictionary. Then someone in the office sent it to me. I think I've got it here. Take just a moment to tell you what meme means, in case you share my ignorance. A meme is a contagious idea that replicates like a virus, passed on from mind to mind. Memes function the way genes and viruses do, propagating through communications networks and face-to-face contact between people. The meme is the basic unit of cultural evolution.
So we have a new one, apparently. Now, of course, it could happen, but I wouldn't bet the ranch on it. The U.S. stock market, however, seems to be betting the ranch on it. It's priced, I think, for the best of times and only for the best of times. But what are the global stock markets? Are they a better bet? Alas, ever the skeptic, I'm a bit doubtful about the global thesis, which essentially goes like this: since the U.S. represents 40 percent of the value of the 20 trillion dollar world stock market, a fully diversified portfolio—truly diversified portfolio—invested in 40 percent in the U.S. and 60 percent in Europe, the Pacific, and the emerging markets, provide the highest future risk-adjusted return.
Risks, so the thesis goes, should be lower because global markets fluctuate in different magnitudes at different times than U.S. markets. But here, history doesn't help us very much. In the 70s and the 80s, for example, U.S. investors in foreign stocks earned returns of 17% a year—terrific returns—versus 11% in the U.S. with not much difference in risk. Was it precedent? Hardly. Was it a precursor? No.
So far, in the 1990s, U.S. stocks are up 17% a year, foreign stocks just 5%, and no one can predict which of those patterns, if either for that matter, we faced in the years ahead. To buttress my skeptical case, I guess foreign returns earned by U.S. investors are heavily influenced, you should never forget this, by changes in the value of the U.S. dollar—every bit as easy to predict as stock prices and interest rates, i.e., not easy at all.
In the 70s and 80s, a weak dollar increased strong foreign returns by 20%. So far in the 90s, a strong dollar has reduced weak foreign returns by 30%. You see no pattern there? In the long run, my best guess is the dollar will be a neutral factor. Returns will depend on how foreign corporations perform, and whatever else may be said, I'm dubious the corporations in France, England, Germany, and Japan will outpace those in the U.S., although I may be exhibiting a bit of jingoism here.
The emerging markets—maybe they will, but the risks there abound and are notoriously unpredictable. Skeptical as I am, however, I will admit there's a place for international investing from a diversification standpoint, and I myself have no hesitancy in recommending an international position—maybe five percent of equities, but certainly not to no more than 20 percent, given the extra economic and financial risks and ever-elusive ability to forecast the strength of the dollar.
Well, we've all been favored with the fruition, as it turns out today, of the ancient Chinese curse: may you live in interesting times. But especially interesting they are, with stocks soaring unprecedented heights as new forces of technology and globalization permeate our world. We can't walk away from it, so deal with it we must.
On that note, then, let me close with five simple principles—a few ideas of what you might want to think about: principles of investing that may help you. First, invest. You must. The biggest risk is the long-term risk of not putting your money to work at a generous return—not the short-term, but nonetheless real risk of price volatility. Even though stocks seem very high, consider what I said in my book—a little plug there: never think you know more than the market does; you have to be wrong if you do.
Second, give yourself all the time you can. At the extremes, if you're in the 20s, begin to invest in stocks—you've only got a little bit. If you're in the 60s, invest more in bonds and lessen stocks. But always remember that compound interest is a miracle and time is your friend.
Third, have rational expectations about future returns and be mentally prepared for market declines. Always remember, in good times and bad times alike, this too shall pass away. I spend a full page in my book on that sage piece of wisdom. If this too shall indeed pass away, your emotions can kill you. You should keep them out of your investment program because impulse is your foe.
Fourth, rely on simplicity. Simplicity above all. There are too many witch doctors in this business with too many basic ideas. Investing is simple: a sensible asset allocation to stocks, bonds, and reserves; a middle-of-the-road selection of diversified funds; a careful balancing of risks and returns. Unless we forget costs, which can kill long-run returns too—don't disregard low-cost index funds. That's my only plug. Warren Buffett just happens to agree, on buttress by his support on the importance of cost and on the value of indexing—a nice third-party endorsement, if you will.
And fifth and last, when you followed all of these four rules, as I said, and I've meant it a thousand times, if not ten thousand times, no matter what happens, stay the course. Good luck in investing in these interesting times. Thank you.