Today's market compared to Japan's mania in '88.... history's lessons... the techniques of
mutual fund managers... Iomega's history and what's to be learned from it....the dangers of investing Social Security in the market

Betting on the Market

Interview with Bill Fleckenstein.

Bill Fleckenstein is a hedge fund manager at Fleckenstein Capital Management.

Q How would you characterize the current market?

The current stock market, unfortunately, has all the ear Bill Fleckensteinmarks of a bubble or a mania. It is very reminiscent of what occurred in Tokyo, especially the years 1988 and '89 where, no matter what news event occurred or what fundamental development occurred, the market simply went up. And you had a period where investors thought that, no matter what happened prospectively, the market would always go up. Risk was completely struck from the lexicon. Nobody cared about that. And, unfortunately, the investment environment today in the United States is very, very reminiscent of that mania. It's particularly dangerous. The attitudes that people have are very similar and if you look at the underlying math between what the prospective rates of return are from the levels of expensiveness the stock market is at today and you look at potential risk from when we've had this level of expensiveness, the risk-reward is skewed out of all proportion.

Q What's so particularly risky about this market?

Just looking at the math, whenever the market has been at this level of expensiveness, whether you look at divided yields or price to earnings ratios or the stock market capitalization compared to entire Gross Domestic Product of the country, whenever you've been at this place where we are now in the top decile essentially, the prospective rates of return have been four-and-half to five percent. On the other hand, there's a very potent force in the world called "reversion to the mean" and a phenomenon markets, industries tend to go in cycles and we tend to see these reversions to the mean. If that were to occur in the stock market, and I'm not predicting it will, but if it did occur, a decline to median valuation levels would be a decline of almost 50 percent.

The risk and reward are out of all proportion. You can try to get a handle on what the prospective rates of return should be from equities. You can look and see what the historical rates of return have been for the last hundred years. You can know what that is. You can look and see what the last 16 years has been, and then you can look and see what's been the rate of return whenever we've had the prices for US businesses that we see today. The returns in the equity market are a function of the underlying rates of return available in Corporate America. Since the '50s, that rate of earnings growth has been about seven percent. In the last 14-hour bull market, the rate of return has been something on the order of 16 percent. That has been a function of a revaluation, or a decision, or a thought process that has caused American businesses to be priced more expensively than they have been. It's the opposite of putting a suit on sale. They've been marked up in price. Same suit, higher price. When you compare what the rewards from this level of expensiveness are, they're rather small, four-and-half to five percent, if you look at statistical data. On the other hand, what often happens in businesses is you have good times and bad times. People are familiar with the concept of recession, boom and bust. And we tend to go from one endpoint to the other. The stock market historically has always done the same thing.

The risk is that if that process gets started again and we only traverse back to what the average level of expensiveness, never mind cheap like we were in 1982 when this process, this bull market started, but if we only get to average, that would mean a decline in the stock market of 50 percent. So the risks are, say, eight-ten times reward. That is not particular a great environment to put all your money in and say, "I'm going to wake up in 20 years and be rich."

Q So why are so many people doing it?

Because people are people. In Japan they had a name for this. They called them the "shin gin ri". And it literally meant "new human being". They were the 20-something year-old people who had no experience in that market who were put in charge of all the investing. And they thought that nothing would ever go wrong. I find it somewhat ironic that here we are, seven years after that bubble burst, the Japanese are still trying to pick up the pieces. At that moment in time we are doing many of the very same things. People are buying stocks for one reason, they are going up. People believe that they're really saving for retirement. That is the mantra today. However, if you look at the data and say, "If I'm saving for retirement, I would maybe be putting some money in bonds and some money in equities." Up until 1994, we would see a similar amount of money go into bonds as equities. In 1994 the Fed started raising interest rates. Bonds started doing badly. People for the last couple of years have virtually no money in bonds and only money in stocks. It's because bonds have gone down and stocks have gone up. If it was just about savings as opposed to speculation and changing higher prices, you would think that people would say, "Wait a minute. I was buyin' bonds when I could get three or four percent. Now I get six or seven. Maybe I should buy a few." So I think if you look at the behavior of people, you can see that it's a classic sign of crowd behavior.

Q In other words, the madness of crowds?

Unfortunately, it's the madness of crowds. Exactly, and people are kidding themselves because think that they really are saving. That don't realize that they're speculating, and there's a huge difference.

Q What's the difference?

Well, first of all, the difference between investing and speculating is when you're investing, I would say you're looking around trying to buy a dollar bill for 60 cents, let's say. And when you're speculating, the intrinsic value of the dollar bill has no interest to you. You'll buy a dollar bill for three dollars if you think you can sell it for four. And in the environment we're in today is much more about speculating. The risk is that the dollar bill's only worth one. And if people believe it's worth three or four, that works until it doesn't. It's the emperor not wearing any clothes kind of an argument.

So in savings, you're much more conservative. You understand what the risks are. You've thought them out and you say, "Well, you know, if I own a five-year bond, I know I can only get, say, six percent, but I know what that is and I'm going to have some of that." In the stock market, you don't know what you're gonna get. I mean people think they know they're gonna get 16 percent, but that's not guaranteed.

Q Have people become bored with the idea of six percent?

I think people probably have become bored with the idea of six percent. It doesn't sound very interesting, particularly when you look at the last couple of years. You're being promised six percent, let's say, but you just found out a couple of years ago that you can actually lose money in bonds. On the other hand, what you think you know is equities, they've returned, say, 16. The last two years have been ever better, and they never seem to go down. If you don't know much about the history of investing and the history of the investment business, which is, unfortunately, most people who have money in mutual funds don't, you might be tempted to say, "Well, why would I want six? I can lose money at six. I can get 16 over here and I don't lose any money. What should I do?" I mean you have to have a certain amount of experience to know that what sounds too good to be true generally is.

Q But people say, "History shows ...

Two interesting points. History does show that, on balance, equities have outperformed every other asset class. However, there have been gigantic periods in time that are longer than what I think people's time frames are where that hasn't been the case. Interestingly enough, the 16 percent rate of return we've experienced for the last 14 years last happened from 1949 to 1963. Over the next 14 years, stocks returned approximately five percent, which is about the same thing that analyzing the historical data would suggest they should return. So you could have a 14-year period where stocks only return five percent. Now, unfortunately, that average period would probably be pock marked with some serious size declines along the way. That's generally what tends to occur. People need to understand the environment we've just been through has been one of the rarest of all time when you look at how long we've gone without any set-backs. The belief that people will not sell stocks in a decline is probably a biggest fallacy that the American public has allowed themselves to be convinced of in the last 20 years.

The Japanese said the same thing. They said they would never sell, and yet as prices went down, they did. Tokyan Fund, their mutual fund assets were reported to have declined by some 90 percent. You can look at that. You can also look at the fact that what did mutual fund investors do in '94-'5 and '6 with the bond funds once they found out they can lose money? They've sold 'em. They've sold 'em and to this date, they really haven't come back. So you have the experience of the last group of human beings who were never gonna sell weakness, the Japanese. They did. Our investors just sold bonds as they went down and now we're supposed to believe that they're going to be immune from any kind of pressure to sell things? I think that's unlikely. The reason we've seen no selling to date is we haven't had any weakness. No one's been tested.

We also have this oxymoron of a mantra that says, "Be full invested and buy all dips." It's not possible to do both those things. You can do one or you can do the other, but when you finally get enough chances to buy the dips, it will stop working, I think. And it takes a long time to become a trained investor to be able to deal with adversity and not panic. I didn't learn how not to panic in certain situations until I did it wrong a few times. The American public now believes that they're new human beings, that they won't panic and they're gonna wake up 15-20 years from now and be rich.

Q Why didn't the Crash of '87 cause people to panic and bail out then?

They did. After the Crash of '87, people did panic a bail out. If you look at mutual fund statistics, they did. They sold 'em for, I believe, the next couple of years. I'd have to look at the data to be certain. They did sell them, okay? And now they kick themselves and say, "Gee, we didn't have to." But fear is a very powerful emotion and, as I've said, you know, we've seen what people have done in bond funds and they've sold them as they've lost money. So I think a lot of the new investors, I think a lot of the people managing mutual funds weren't even around in '87. It was just a down tick on a chart and they said, "See, but if we hadn't have sold, we'd have been okay." But the people who were in funds then actually did sell.

Q What do you mean when you say fear is a very powerful emotion in the market?

Well, people are buying stocks right now because they're afraid or they fear they're missing something. And so they've gotten a little bit greedy. And people can understand that thought process, but the fear of losing money, of seeing stocks you own go down relentlessly -- and it's not so much over a week or two. We've now seen a couple of smaller declines and have come back, but if stocks went down for a protracted period of time, which, in this case, would be as little as maybe a quarter or two, we haven't really tested people's resolve in a period that lasted as long as 90 or 180 days. Then I think people would start to think, "Well, gee, what if it doesn't work?" Once that confidence has been broken, then you start to have a little bit of fear and the fear of losing money, even though people haven't really experienced it, is far, far more powerful than the fear of not making it.

Q Where do the mutual funds fit into this whole schema?

The mutual funds have been the vehicle through which the American public has put money into the stock market. They are the vehicle of choice, and part of that's because you've got daily reporting. People can now look up and see how they're doing on the hour at the end of the day and how their funds are performing. But this has been the way that the public has gotten into the stock market. Unfortunately, because of the daily reporting and the way the system works, I think it's fomented speculative techniques in the way money is invested. This notion of momentum investing that is the sort of the vanguard of the mutual funds, to me, is an oxymoron. Momentum investing is not investing, as I find investing to be trying to buy a dollar for 60 cents. It's the belief that you can buy a stock for three dollars and sell it for four dollars.

What's particularly interesting, one might say dangerous, about the present mutual fund boom is that techniques that the portfolio managers use. Peter Lynch is held in great esteem. He was a terrific -- is a terrific investor. Unfortunately, the techniques now being used by all the top funds don't have a lot to do with what Peter Lynch used to do in terms of trying to really dig through and get all the research and be a fundamental investor. What is going on today, what is called "investing" is really speculating. The notion that "I can guess which way the crowd is gonna run next and I'll get there before them." The techniques are more about trading, rapid turnover, paying any price for a stock as long as it goes up or behaves a certain way. It is about crowd behavior and stock price behavior, not about analyzing the underlying businesses. It is 180 degrees away from what Peter Lynch did or what Warren Buffet does. The people that are held up as the genuine heroes in the investment business for the last 30-40 years are investors. What goes on today is not investing; it's speculation.

Q So the managers are managing the same way that we would buy stocks ourselves?

I think that's an accurate statement. There is not a lot of difference between the way that goes on or the way a relatively unsophisticated or untrained individual might go about doing it. I mean there's a lot of fancy techniques and there's gonna be a lot of computers and there's a lot of buzzwords like "stochastic" and "relative strength" and a lot of these type terms. What's different about this bull market is everyone's got at least one or two computers on their desk. We never have had this in the last bull market. So there's all kinds of fun computer techniques you can turn loose on stock market action. So it's analyzed to death and it's acted on and because the prevailing tend is up, it has worked and to the extent that a lot of the key guys have pursued the same techniques, you've had a bit of a self-fulfilling prophecy. So a lot of these what may historically be looked back on as questionable investment techniques all work and work spectacularly right now.

Q Tell us about your prospective about Garrett van Wagoner.

Well, I think Garrett has been the very best mutual fund manager throughout this entire 1990 to '96 period that we've seen so far. He has demonstrated an absolutely extraordinary ability to be in the right areas at the right time, and I think, to his credit, he has been quite good at avoiding areas that weren't gonna work. He's got in incredible instinct for knowing which way the wildebeasts the gonna turn and run next. I think he's been without peer in this. He's done a great job so far and I think he's avoided a lot of the troubles -- so far.

Q How much risk is entailed in being in his fund?

Well, I mean that's an excellent question. I don't know for sure, because I don't know what goes on. My hunch is that there's quite a good deal of risk if the equity market isn't going to go perpetually straight up. I think, unfortunately, one thing the public doesn't understand is, a track record is fine, but what matters is when you get in the fund. What often happens in funds is people start out with a small amount of money. The numbers are great. And then human nature being what it is, all the money comes after you've had a great period. And almost inevitably, any investor tends to have a bad following a great period. It's very hard to have a great period, great period, great period and no intervening set-backs. What tends to happen is, people come in, put all the money in right before a set-back occurs.

Q How much risk does Garrett van Wagoner take in his investment?

I don't know precisely how much risk he takes. It's not a knowable thing. All you can know is that these types of techniques -- you can look at the underlying securities. Inherently, businesses that are valued the way these are, with the historical data that you can look at, are inherently risky. As a portfolio, a collection of those things is still inherently risky. I think that one thing that people don't understand is that just because someone has a terrific track record doesn't mean that there might not be a certain amount of risk associated with it. What often happens is you'll have a fund manager will have a hot period and then, human nature being what it is, investors will put a whole bunch of money into the fund just before the investor has a bad period. So I think that's something that people need to focus on is, what happens when they enter these funds? The volatility can be quite large. A fund such as his is liable to be quite volatile. And I suspect the risks are quite high.

Q It would be very useful for you to tell us, in percentage terms, what Garrett did this year.

I think in Garrett's fund's case, it was very fortunate he started a new fund early this year. And I think by May, he was up close to 60 percent. Unfortunately, what I think tends to occur, and it's kind of an example of what happens over and over again is, at the beginning he had very little money under management. My guess is, as he got close to being up 60 percent, he probably raised 80 percent of the money he has under management. And then there was an intervening period where I think his performance decline as the market took a bit of a hit in July. So it's quite likely that the overwhelming majority of his investors, their first taste of his performance was a sharp set-back. And now the market has come back and its performance has done well again. But I think that is something that happens over and over again as people tend to chase hot money managers.

Q Talk about your views on mutual fund marketing.

The investment business has changed dramatically in the last 14 years. When I first got into the investment business in 1982, the investment management business was about making money and controlling risk. What people were particularly concerned about was how did you do in previous periods where money was lost? How well did you protect them? The focus was 100 percent on "Let's not lose much money and the up side will take care of itself." That has changed. We've gone 180 degrees in the other direction. Now the investment management business has become the investment marketing business. And hot fund managers are well known, like all-star athletes. Everyone knows who Garrett van Wagoner is and Jeff Vinik, Ron Elizia. I mean so these are household names. The public has been told that if they just keep putting money into mutual funds, they will be able to retire rich, as though it was a simple process. I don't believe it is. It is not that easy to get rich and it is not as easy as just putting money in the funds and waking up magically down the road and being wealthy.

Q Is society putting too much emphasis on making money in the market?

I think probably when we look back on this period, it will be clear that there was way too much focus put on the equity market. This is a rare period in history. A lot of the things that are occurring in terms of the behavior of mutual fund buyers, the behavior of society in general towards the market with the TV station focus and the newspaper folks and all that, these types of things only happen like this every couple of decades really. This is very rare period. So we are putting too much focus on it. It's a consequence of the mutual fund boom that got started in 1990 when the Federal Reserve lowered interest rates to three percent. And it'll be with us until it stops, and then it won't be like this anymore. That's a hard thing for people to believe. People don't believe it will ever stop, but, again, if you look back at Tokyo, they didn't think it would ever stop. They were proven long-term investors. They were compulsive savers. This is not debatable. The Japanese as a nation is known for this, and yet when their bubble burst, they got out.

Q Have we come to believe that retirement money will provide this kind of endless throw into the market?

Absolutely. People believe that the retirement flow of funds will power the market eternally in the same way that the Japanese believed money would always be there. We have our own set of triple merits. We've got the economy well under control. That's what people believe. Inflation will never be a problem. That's what people believe. Interest rates are always on the verge of going lower, even though that hasn't been the case in the last couple of years. So we have this belief of a virtuous circle and money will always come in and stock prices will always go up, and money will keep coming in and it will just go on like that. However, there are signs that the process is starting to end. We need about three to four billion a week now to keep the market stable. People forget that Wall Street is in the business of creating stocks and they're doing' it hand over fist now. That was one of the reasons why we had the decline in July. So while the money is gonna come in, it's going to require an ever-larger amount of money to keep the market going up.

Q Have there been signs this year that we're reaching a peak or that we're coming to a point where we should worry?

Trying to determine what the end of mania is almost impossible, because, by definition, you're not talking about investment ideas and logical analysis. You're talking about the madness of crowds, which are very difficult to get a handle on. However, last year we put approximately 120 or 130 billion dollars in the stock market and the S&P 500 rose almost 40 percent. Halfway through the year we've already put in that much money and then some. And the market's up a quarter as much. So you can start to see already that we need ever-larger amounts of money to power the market higher. We will get to a point where there is not enough money to keep the market going, since it is rising faster than the underlying earnings. It is all about revaluing businesses higher.

I believe we're starting to see signs now that suggest that we may be getting nearer the end of this process. By definition, trying to figure out what will end the mania is impossible. It's about madness of crowds, not logical investment analysis. So it is very difficult. But in 1995, approximately 130 to 140 billion dollars, roughly, went into mutual funds. The S&P 500 was up 40 percent. That was the most money that had ever come into funds. In 1996, approximately -- more money than that through the first -- through the first three-quarters of the year came in and the S&P was up a quarter of that much, a sign that maybe we're running out of money to power the market ever higher. Yes, money can come in, but people forget about the fact that Wall Street does nothing but create securities for a living, so they're going to come up with a new supply, and eventually there won't be enough money to keep pushing the market up faster and faster above the underlying rate of growth in corporate earnings. We have been growing twice as fast in terms of market rate of return than the underlying earnings. And that's about revaluation. That process can only go on so long.

Q Is Main Street now driving the stock market?

It is 100 percent fair to say that Main Street is driving the stock market right now. That is the driving force. If you suspended mutual fund in-flows for three or four months, I would be willing to make the observation the stock market would decline 10-15-20 percent. It's not just that the money is coming in. It is the way the money is then slammed into the marketplace. When you have a year where the market gets $130 billion, like 1995, and the market goes up 40 percent, you may create almost a trillion dollars in market capitalization, so that you have sort of a ten-to-one kind of effect. And to keep that up, it is a requirement that you continue to get sufficient amounts of cash flow that can continue to get jammed into the marketplace rapidly.

Q What is "jammed into the marketplace"?

What I mean when I say "jammed into the marketplace" is, again, in the old days, say, even in the '80s if you were a money manager, you would get money and you'd kind of take your time about buying your stocks. You wouldn't want to go in and force the price higher simply because you wanted to own some more stock, because you were buying stocks that had some valuation compared to the underlying business. Today, part of the game is, "Hey, let's move the prices of the stock up. Let's jam it in. Let's go buy it sort of as sloppily as possible. Let's make the price go up while we're buying it and then when we get more money, we'll keep doing it." There's a very large element to the self-fulfilling prophecy aspect of this, which works until one day not enough money comes in and then you have a real debacle. This is also what increases the risk. This is why these valuations of these businesses are at record levels now.

Q Talk about Iomega.

I believe that when the history books are written about the year 1996, when people look back with a little perspective, the year 1996 will be remembered for the year -- sort of the Internet captivated people's imagination and not just Internet investment ideas, but the Internet as a stock-swapping or stock-touting medium. And whereas the poster boy for this go-round in the mutual fund area has been Garrett, sort of the stock poster boy, if you will, would be Iomega. It embodies everything about speculation, Internet chat rooms, taking a company with a good idea that had a decent product and taking the price of the security, i.e., the price of the business, and taking it to absolutely outlandish proportions. Everyone was willing to play that game as long as it worked. And then the stock price peaked, it started coming down, and now people aren't as interested. And it's almost a perfect little window on what can happen in the stock market in general. There was no particular cause. Nothing bad happened at Iomega. It just got too high. Finally it got too high. Marginal sellers appeared, as opposed to marginal buyers every day, and the thing tipped over and then started collapsing because the way it went up was so unhealthy. That's what happens when these kind of investment techniques, if that's what you want to call them, when they start to unwind, that's the way they unwind. Iomega was the first one that was really in the news where this happened and then unwound. But you're gonna see more of this.

Q What were investors after with Iomega?

They were trying' to get rich. People that owned Iomega stock were trying' to get rich. And, hey, it worked. I mean a lot of people have still made extraordinary amounts of money, depending on where they got in. I know a lot of people must have lost a lot of money, but I would have to believe -- I don't know what all the participants thought. I would have to believe there was a certain amount of just throw caution to the wind. In this environment everything works. We have fomented an environment where the more speculative, the more risk you take, the better do. Where have people been taught a lesson about these things? So far, it really hasn't happened yet. I think people were just being greedy. People get that way. People are people. Human nature never changes. That's the fallacy in this whole argument that we'll never sell. People are people.

Q Can one make the same argument about van Wagoner Emerging Growth Fund?

I would say, unequivocally, people that are buying Garrett van Wagoner's fund don't have the faintest idea what he does. All they know is he's been spectacular at makin' money, produced monstrously large returns, been very few set-backs, and they want to own some. They, too, want to get rich. They say to themselves, "Gosh, if I'd have put one dollar in this back then, I'd have X number of dollars today." So people are buying things for one reason, and one reason only, because they've been going up, they think it will continue, they want to get rich.

What Peter Lynch basically advocated was that you, as an investor, any person in the country, had the ability to be a successful investor by simply noticing what was going on around them. Everybody is good at something. Everybody knows a little bit more than someone else about something. What he advocated that you do is, capitalize on that. If you're in the airline business, some business that relates to that, that you can do well at. Do that. Capitalize on it and stick with it. That is a far cry from saying, "Okay. I'm going to go put money in the hottest fund around and I'm going to tell myself that if times get tough, I'll buy more." That is now what he was talking about. He was talking about investing and doing your homework and using your own good common sense and things you knew about. What's goin' on in the mutual fund business right now is simply rank speculation. People think that they have reinvented their own human nature, that they will never panic in a tough period. That is, every time in the course of history when people have said to themselves, "People are different," or "This time it's different," it is always unequivocally ended badly.

Q Have you been through a bear market in your life?

Yes. I've been through a bear market, although at the time in the 19-really-79-80-81 period there were some difficult times. In the first half of 1982, the problem was, you couldn't have a really violent bear market because valuations were so cheap. In 1980 and '81, stocks sold for book value. They had five percent divided yields. So a bear market -- the market went down five-six-seven-eight percent, you could find industries that did worse, but even that was a scary process. People were terrified of the stock market back then.

Q Isn't it true that just as today's psychology is "We can't lose in the market," the psychology then was "We can't win"?

Absolutely. The psychology in the early '80s was, "Stocks are very risky. We might speculate in them," or "We might put a little bit of money in 'em, but we're not puttin' any real money in 'em. We're puttin' our real money in these CDs where we can get 14 percent." That was a good risk-free rate of return. Bonds were for complete losers. People wouldn't even touch them. Now that stocks are now the highest valuation they've been in history, people think they can not lose in them. It is a very perverse thing about markets that almost always when the risks seem the highest, they oftentimes are the lowest, as was 1982. And when they seem the lowest, they're actually the highest, like right now.

Q Is a bear market inevitable at some point?

I believe a bear market is inevitable at some point, yes, simply because in Nature, in life, in everything there are cycles. There's no such thing as the elevator that only goes up, which is what the stock market is in people's minds' now. The consequence of it going up in changing people's behavior and pushing prices to where they are and all this is almost inevitably you have a bust. Similarly, when you have a bust, you set up the next boom. So these cycles occur for reasons. You sow the seeds of the next problem. I think it is inconceivable -- we will have a monstrous set-back in the stock market. I don't know whether it's gonna come from 6000 on the Dow, 8000 or 10,000.

Q What do you think of the idea of investing some of the Social Security money into the stock market?

That is the greatest fallacy of all time. The idea that you can take money out of the Social Security Trust Funds and put them in the equity market is completely and utterly impossible. People don't understand there is no money in the Social Security Trust Fund, no as in "none". The money was spent to operate the government. When you send money to Social Security, it goes into the government's coffers. They spend it and they place an IOU in the Social Security Trust Fund. There is no money. If they want to take Social Security Funds, they will have to sell bonds and raise the money to put the money over there. Every dollar, prospectively, that you do not send to Social Security and Social Security forwards to the equity market, they'll have to borrow an additional dollar. The government finances are set up such that any program that generates revenues currently, like Social Security, gets counted on the budget. Anything that loses money is off budget. Therefore, you have certain nonsensical trial balloons like this and when the government comes out and says, "The budget deficit is 120 billion," that is also 100 percent false. The National Debt increases at about 150 billion. It's these different programs, like Social Security, that cloud the issue.

Q What does it say about where we are that this would even be on the table??

It's hard to find an adjective to describe how completely ludicrous this idea is, because taking Social Security money and putting it into the equity market. It tells you you're very, very late in the game. How late is late? Well, it's not knowable, and we're talking about crowd madness here. There isn't any money! There's no money there to put into the equity market. The fact that serious people have floated this trial balloon and it's appeared on editorial pages of serious newspapers around the country, tells you how gullible and how believing everyone has become at this moment in time, I think. People have lost their sense of any sort of skepticism. Any idea, as long as it results in some way, higher stock prices, is what people want.

Q How about the loss of safety nets?

Yes. I think that the notion that the stock market is the only way we can retire happily and we really need it to help us is a very dangerous thought process. I think that is what people believe. The truth of the matter is you can get more and acceptable rates of return in the bond market now. This notion that the equity market is the only thing we have is just not true. From today, over the next five or six years, people will almost certainly do better in government notes than they will in equities, and, of course, the risk of not losing any real money doesn't exist. People have confused need with certainty. We need this to work. It seems like it will, therefore, it will. That's a little bit like going to the track and betting on number three and saying, "God, I really need this horse to come in for me." Well, just because you need it to come in doesn't mean that it will. However, with equities, there's been this reinforcing notion that if we all need equities to work and we all put our money there, then somehow it'll all work for us. Like everybody agrees on the same thing, that it has to work. That can be a self-fulfilling prophecy for a while, but in the end it can't work.

Q For all the marketing that they do, how many mutual fund managers actually beat the market in a given year?

I think when people look at performance and they see that an indexed fund would have done better and for all of this research and that some mutual funds don't do better, I think what is happening is that people are showing that their sort of lack of understanding of the exact process. The idea is, any good investment person will have good years and bad years. The trick is to find a good person who knows what they're doing and stick with it. So much of the focus has been placed on the short-term that people are looking for the hot person and then as soon as they have a bad period, they tend to get rid of 'em. And all of the types of techniques we've talked about foment lots of turnover and things like that, it's not surprising that, on average, given the frictional costs and the marketing costs and all of that, that, on average, the whole group of mutual fund managers under perform the index. It has to be. As a large group, they're going to be average and when you figure in the cost, they're gonna be below average. That's not to say you can't find people who are going to be successful.

Q So why should you be in mutual funds then?

I think that, well, I mean I think the case for equity -- mutual funds are equities. I know a lot of people in the country think that mutual funds are some special investment vehicle that they bought at the bank that is somehow guaranteed. That's not the case. Mutual funds are a portfolio full of equities. The reason to be in equities is historically equities have been the best asset class. That's fact. But by buying a mutual fund does not reduce the risk of holding equities. It doesn't mean simply that "It is always going to work now because I own a mutual fund instead of buying stocks in general." What people have done is, they've said, "I can't pick the equities. I'll give it to the mutual fund manager." But now what's happened is they've had such a taste of success, they want to go pick all the mutual fund managers and now they're back in the process again. It gets back to the fact that the process has appeared to become riskless.

Q Are people trading mutual fund managers the way they're trading stocks almost?

I can't answer that question, but I suspect people do. I mean fund prices in some of these fund groups are made up hourly. You can switch 'em hourly. Now if you're really saving for the long term, why do you need to do that? And would the mutual funds have allowed you to do that if they wasn't demand? So there's got to be a huge amount of speculation and swapping around hourly, daily. That's not about saving for my retirement. That's about speculating, which gets back to the heart of what the whole process is about.

Q And speculating is basically betting that something is going to go up because it's going up?

Speculating is basically betting that something is going to go up because it has gone up and you think it will go up and you forget the price of the underlying security. When you forget about the price of the underlying security, you induce the risk. When you pay more, far, far, far more than a business is worth, if the belief that nothing can go wrong is shattered, the risk you're taking is quite large.

Q Talk about the decline and fall of Jeff Vinik?

Well, I think that the decline and fall of Jeff Vinik, first of all, I think probably expectations got too high. It's a very, very large fund. It's a very difficult job -- I think that as people's expectations of what you can do with a 30- or 40-billion-dollar fund were too high. He made an investment decision about owning bonds and some cash and not to be as exposed to the equity market. And subsequently left Fidelity. People have tended to make a lot out of this, that this goes to show you that you can't hold cash, you can't hold bonds, you must always own stocks. If that is the right analysis, it does suggest something about how rabid people are for investment performance. Supposedly, they trusted money to a person to use his best judgment. He used his judgment and when it wasn't exactly what they wanted, they didn't like it.

Q And it's over a very short term.

But short-term is what this it really all about. I mean it is just another irony that while people are telling themselves that they're saving for the long term, they're looking up how they did in the paper every night, every weekend. Portfolio managers are shuffled 'cause they don't do well in the short run. And that's more because if they don't do well in the short term, then the fund company can't raise more money. It doesn't necessarily mean that the person doesn't know what they're doin'. We have these hourly switch funds, as we have seen. You can change your money around in these funds daily, hourly. So we have all these techniques set up to maximize the short run. Meanwhile, we're tellin' ourselves, "But we're really doin' it for the long run."

Q Do average Americans have a wherewithal, the ability to fight envy, to deal with fear and greed ...

That's a very good question. It's a very difficult question. The thing you fight as an investor is trying to make sure that you're right. I mean it's not easy to be right, you know, often enough to have a successful batting average. The other thing you have to fight are your own emotions, because along the way to being successful there are going to be a number of head fakes, where the stock you own goes down a bunch for no real good reason and you have to know to hang on. So there's a fortitude issue that people can learn. It is much easier to have the right fortitude and the right constitution about an investment, the more you know about it. And that is the fallacy with this mutual fund mania that's going on now is, people are not really sure what they own. People are smart enough to be good investors if they would just apply a certain amount of homework. A lot of times people will go buy a new car or a dishwasher or a microwave and they'll get out Consumer Reports and they'll do a ton of research. I think that people do more research on small investments around their house than they do about their investments. If they would apply that same amount of research, stick to ideas they understand, then when bad times come along, they won't be as easily shaken out. So you can be a better investor by doing more homework. I don't think the same amount of homework is going on right now in the equity market, which is one of the reasons why when the inevitable tough times come, as they always do, people will find it much harder to not sell than they think.

There have been a number of proposals about taking money out of the Social Security Trust Funds so that the money can then be invested in the equity market. Also there've been proposals about allowing people to not send money to Social Security and having that money then put in the equity market. The problem with these proposals is, there is no money in Social Security. It is not possible. Social Security only has government IOUs in 'em. That money has been spent. It is not there.

Q So why are people talking about these proposals?

The reason people are talking about these proposals is because it has now gone far enough -- the Social Security was meant to be a safety net. The investments were meant to be as safe as possible, since it was a safety net. People have so little regard for the risks associated with equities that they now think they can take the safety net's assets and that were supposed to be in the safest place possible, and put 'em in a risky asset class at a time when stocks have a highest valuation ever. That speaks volumes about the psychology of the day and the fact that people think stocks can only go up and contain no risk.

Q What is it going to take for people to realize again the risk inherent in the stock market?

I suspect that people won't realize the risk in the stock market until they start to lose money. You get to a chicken-and-egg type debate. "Well, how can the market go down as long as money keeps coming in?" And without getting into a lot of complicated discussions about marginal pricing and things, believe me, it happens. We saw it Tokyo. We saw it in our bond market here recently in 1994. There was no way the bond market group could go down, and yet it did and investors sold. What will happen is, we will simply get too high. They won't be enough new money coming in to keep the market going up. Losses will start and losses will beget losses, and then people will be people and they'll sell.

Q Inflation.

At the end of the '70s and the early '80s, the fear of inflation was everywhere. People believed, and you can go back and read articles that were written at the time, that there was no way the inflation rate was ever going to be brought under control. It was in an unstoppable process. And as a result, you got long-term bond rates to 14-15 percent, CD Paul Volcker took rates to 20 percent. And stock prices were very depressed. But that process, that fear the mandate the Fed was given to break the back of inflation, in fact, did. That is what set the stage for the monster bull market we've had since 1982. The breaking the back of inflation, the lowering of rates, the rise in valuations on top of the more or less up economic growth we've had for the last 15 years that has been pretty uninterrupted save for a little bit of period in '90-91, that breaking the back of inflation and the fear that it had engendered going up to that is what got us in the position to have this bull market. It got equity prices too cheap and it got economic policy set in the right direction and that's what produced this monster bull market.

Q Didn't it also, though, cause middle class people for the first time in a generation to have to begin to take control of their own finances ...

No. I think that what it did was, it pushed them in CDs to take advantage of the high easy rate of return. Coming out of the inflation period, stocks and bonds were dirt cheap. We were pursuing policies to break the back of inflation and make stocks and bonds a great asset class. Unfortunately, human behavior was, "Well, let's buy CDs and let's buy hard assets." People didn't buy the stock boom until it had gotten way underway. You didn't see large pick-up in mutual funds 'til '86 and '87. Then you had the crash and then there was not much activity in mutual funds until we had the recession in 1991 and the Fed Reserve took interest rates to three percent. That's what started this boom.

Q Do you have some stats on how much money has come into mutual funds, say, in the last three years as opposed to any other period in history?

Well, I can just to put it in perspective, in 1982 there was about a 100 to 200 billion in mutual funds. Right now there's about a trillion-five. As recently as the early '90s, stock and bond mutual funds had about the same amount of money.

Stock funds have grown dramatically in the last 14 years.

1982, stock funds had about 100 billion dollars in 'em, but the epic growth has really kind of happened since 1990. In 1990, we had about 200- to 240 billion dollars in equity mutual funds. Today, only six-seven years later, we have almost a trillion-and-half dollars in equity mutual funds. That's a staggering rate of growth.

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