The trouble with prosperity...
why I'm bearish...
the one single, settled truth in finance...
the lessons of
October '87

Betting on the Market

Interview with James Grant.

James Grant is founder and editor of "Grant's Interest Rate Observer" and author of " The Trouble with Prosperity."

Q Have we reached the point where people don't know what it is to lose money in the market?

James GrantPeople never exactly forget what it is to lose money, but it is something that is not in the front of their minds at moments such as this, of great overwhelming prosperity. I think the fear of loss is a little bit like the fear of a punch in the nose. You never exactly forget it, but it is never exactly in the front of your mind until somebody is sailing a fist toward your face. So it's something that people never exactly lose, but they can tend to forget momentarily.

Q What are people's expectations of the market in the last two-three years?

What people expect of the market is 12 to 15 percent a year, year-in and year-out as if it were a part of the U.S. Constitution.

Q What should they be expecting?

I think people should expect the stock market to deliver good returns over time, with the understanding that from time to time it will tear your heart out. The stock market is a little bit like a savage beast. It is nice thing to think you've domesticated, but every once in a while it'll remind you suddenly maybe by taking your hand off, that it is not the pet you think it is. And people over the course of many, many prosperous years have come to think they have domesticated this beast when in fact I think they have not.

....You know those of us who are truly ancient in years and in time in the library recognize the stock market for many periods before this golden age, this mutual fund era, the stock market has been-- for 20 years it's been a veil of tears over not a few 20-year periods the stock market has done not much of anything, or it has disappointed. Now I think it is simply not meant for people to count on something as a sure thing in finance. It never has worked and I think that what's wrong with prosperity finally is prosperity itself.

Q How much has been driven up by mutual fund mania?

The full flight from cash, from Treasury Bills, from low-yielding bank deposits into mutual funds has been at the heart of the stock market's performance for many years, culminating in 1996 in which for the first six months or so the stock market was the recipient of approximately $20 billion every months. It's astounding. Of all the money that's ever been invested in stock mutual funds, most of it, the great bulk has come in since 1991. It is hard to exaggerate the sheer weight and power of this money. And, we've all come to take it for granted, but in the scheme of things, it is unique.

Q What does that suggest to you about the investors and where we're going?

Well, this unprecedented flow of money into the market certainly constitutes powerful evidence that people expect great things from Wall Street. And I have an office on Wall Street. I can look out the window and I can see cued up to visit the Stock Exchange, to kind of go in the visitors' gallery and watch their wealth fructify. They want to go in there and watch the stocks go up. It's like they're visiting some French cathedral. They're out there taking pictures in front of this building, this Mecca.

And I think people have come to see the stock market not as this intersection in which there're buyers and sellers and the fruit of long-term appreciation in business is somehow cultivated and harvested periodically, cyclically. They've come to see it as more or less a permanent annuity. I think that the process of a bull market is it's self-limiting and prosperity is self-limiting. And, that's what we're seeing now.

Q What do you mean?

Well, the trouble with prosperity is prosperity to the extent that more and greater performance in equities induces more and greater issuance of equities. Companies, seeing the valuations being accorded the other companies, issue stock. People buy it. With the proceeds of the issuance, companies do things. They build a plant. You can see it most clearly nowadays in semi-conductors this most wondrous commodity of the Computer Age. In the fall of 1995 an announcement of a new semi-conductor fabrication plant, FAB, as they call it, you know, was tumbling out of a fax machine about one a week. So as the market ripens, as companies issues more shares, as they receive the proceeds from those shares, they make investments.

Well, presently on form they will make the fatal additional extra investment that will be unprofitable. You're seeing it in semi-conductors, that the price of the semi-conductor has collapsed. Why? Well, in part because of the excess investment in that department of business activity. So you can't imagine a world in which stocks go up all the time because they would be too much investment. The investment would prove unprofitable. Companies would begin reporting unprofitable results and the market would go down again. So in the nature of things, prosperity is at some level its own worst enemy.

Q Do you think the bear market is coming?

Joe, I'm bearish because I was dropped on my head. (Laughs) Don't use that. I think there are types of people who can't abide a settled consensus of opinion, bloody-minded, contrary types of people. And I have often confessed that I am one of them and I hope to be just as contrary when people hate this market with a unified passion which I have every confidence of their doing. But what has made me bearish over the years has been, in part, the unprosperous turn of mind, in part, you know, the usual litany of complaints about valuation and the like.

Q How far out of hand have things gotten?

Well, it seems to me that the 1996 model stock market is the most overwrought, over excited thyroid case, if you will, we've ever seen in this country. It is a remarkable specimen. It is a case study in what they call on Wall Street overvaluation.

"Overvaluation" is a fancy word meaning that stocks are overpriced. I mean people wouldn't go out and seize on a $10,000 refrigerator when they could buy a $3,000 refrigerator. What is unique about speculation and investment is that stocks somehow become more compelling bargains to the average investor as those stock prices levitate. And stock prices going up cause people who would not have dreamt of buying them when they were down to go out and buy them, because, after all, they will continue to go up. So this has been the psychological backdrop to this market and the manifestation of this psychology in the marketplace has ...

Q If stocks have become overvalued and people know it, why do people buy them?

Well, overvaluation never stops a bull market, nor does undervaluation stop a bear market. In other words, at the bottom of this market, and no doubt one day we'll have a bottom. And at that bottom, people refuse to consider buying a stock that is really being given away. That's the definition of a major bottom of the stock market. Similarly, at the top, people pay no heed to what, objectively is unprecedented or at least extreme levels of overvaluation. Why? Because they know it'll go higher. At the bottom, they know it will go lower. These truths are absolutely the only certain thing in finance. Everything else about finance is variable and contingent. The only permanent truth in finance is that people will get bullish at the top and get bearish at the bottom.

Q Are people being sold a bill of goods by Wall Street and the mutual funds industry?

Wall Street is no more fraudulent than the American electoral process is. Who elected those boobies that sit in these congressional seats that everyone deplores? Well, the people elected 'em. And insofar there is fraud being perpetrated on the voters, it's the voters who have elected the officials. Similarly in Wall Street. I mean is the mutual fund business pulling the wool over the eyes of the sheep?

...It's not as if the mutual fund business is kidding the public only. The public is, if not kidding the mutual fund business back, it is the most willing dupe ever. I mean in old-time Wall Street, the public was cynically painted as a bunch of sheep and brokers were shearing the sheep from time to time. Well, we can't exactly say this now. There is so much financial television. There is so many good financial books. There are so many thorough financial periodicals that it's hard for the public to plead ignorance, although I have no doubt that come the inevitable congressional hearings that will follow the inevitable break, there will be pleas of ignorance and abuse just as there was by this sorry specimen of a professional, this man Citron in California, who is now -- who went from the state of omniscience to the state of amnesia in about six weeks, the six weeks entailing threats of a jail term.

So it's in the scheme of things that people will get bullish at the top, it's the scheme of things that people will blame the brokers when the end comes, but I think this time especially it'd be hard for them to maintain that with a straight face.

Q What do you think of Peter Lynch?

I wish I had as much money as Peter Lynch has. (Laughs)

Q Do you think he's part of the problem or part of the solution?

Peter Lynch has said one thing about the stock market for a long time, and that one thing has helped a great many people to make more money than the American public probably ever dreamt of making. Now, as I say, there is not one single settled truth in finance, except for the truth that people will over-do it. They will get bullish at the top and bearish at the bottom. Good ideas will be taken to extremes. Peter Lynch has and has had a great idea. I think the time of that idea is over. I think Peter Lynch's mistake is to treat the idea that stocks appreciate as not so much a tendency but as an iron law. It ain't an iron law. Stocks don't always appreciate. They don't always follow earnings. Much can go wrong in human affairs and does. If it didn't, history would make a lot duller reading then it does.

Peter Lynch's great idea is that stock price appreciate over time, but there is no one single settled truth in finance except for the fact that people will over-do it. They will get too bullish and then too bearish. But it is simply not true that stock prices always follow earnings. It's not. If it were as easy as that, everyone would be even richer that Peter Lynch has implicitly promised they can become.

Q So what's it like to have been bearish in the midst of this epic bull market?

To have been bearish in the face of this titanic rise in stock price is a little bit like being bearish on a hurricane. You're going to stand out there and decry the force of Nature, but it's hard to make much headway against it. It has been a truly humbling experience. You stand up there and say "The market" -- okay, "The market can't go up." Okay. The market's up. Fall-back position. "The market perhaps shouldn't go up." Well, didn't work. Fall-back position. "The market" and so forth because the market continues to fly in the face of every single received rule, evaluation and prudential investing that I know. So it has been a very rough go.

Q Are people deluding themselves that investing in the market is going to solve their problems?

At the end, every single received investment truth is a delusion. At the bottom, the notion that stocks will forever disappoint, that cash and safety are the highest ends in finance, that idea will prove a delusion and a disappointment. So at the top, the idea that stocks will deliver me from the need of working 'til the age of 65 will free me from the drudgery of nine-to-five work, with just a little bit of clever cruising of the Net, I, too, can be an inside, be just like Peter Lynch and buy low and sell high. So the stock market is full of delusionary ideas and the characteristic delusion depends upon the height or the depth of the market. And now I think we are at one of the all-time unseen highs. Certainly it's been unseen as a level of the Dow and the characteristic delusion is the bullish one. But there is plenty of delusion to go around.

Q What about Johnson & Johnson, Merck, AT&T as opposed to the IPOs and the small caps and so on? Same thing going on there?

In any market too high or too low or in between, there are always stocks to buy and always stocks to sell. There are companies that are fairly valued in the midst of the greatest mania. There are stocks that are overvalued in the midst of a really bad sell-off. So I don't mean to impugn every single listed and NASDAQ stock. It's a truism, though, that when the market turns down, the worthy as well as the unworthy get taken out and put through the ringer. Similarly in the rise, many unworthy stocks get carried along with the up side.

But it is not true that the great solid blue chips, are exempt what happens to the rest of the list during a sell-off. I mean in the bottom of the last really powerful bear market we had in 1974, "they", meaning the market, you could buy Boeing for less than the value of the cash on its balance sheet, if my memory serves.

Q In '73-74 if you were that market, did you think, "Oh, I'm never coming back here again"?

Let me tell you about 1974-75. A friend of mine got into the business in the early '70s and climbed into the taxi cab about 1978. This was three years after the bottom. And the cab driver asked him what he did and he told him he was in Wall Street. And he said, "Wall Street?" They still sellin' that crap?" (Laughs)

It is impossible to exaggerate the degree of revulsion that the public feels towards common stocks at the end of a powerful, an epochal bull market. That is the term of art, by the way. It's called revulsion. It's not bearishness. People just can't stand the sight or the sound of it because there's been so much money lost. There's been so much energy expended. There's been so much hope destroyed. And that is called an opportunity. This is where great fortunes are made. So, you know, there is a lot to be said for a bear market. It clears away the debris of are preceding boom. It puts paid to a lot of mistakes and it gives people a chance to buy great companies cheap.

Q What happens in the taxi these days?

What happens these days when you climb in the back of a cab is they give you a stock tip. This happened to the publisher of Grant's Interest Rate Observer leaving the hospital after the birth of a second child. Gets in the cab, the cab driver reads the expression on his face that he has had a child, he's out of New York Hospital. And he said, "Look, I was going to tell you to buy a lottery ticket. Instead, there's this great common stock, Epitope." (Laughs)

Q Tell me about psychology of the market.

Well, what the market is not about, except on very rare clear , temperate days---it's not about individuals making calculatedly rational choices, discounting the future value of earnings at a certain discount rate. It's not about that generally. Sometimes it's about that. It is about a great ebbing and waxing movements of psychology, of crowd psychology, especially at a time like this when the market has been doing so terrifically for so many years.

But people see an individual stock is not so much, you know, future earnings discounted to the present day. What they see is the main chance. They see the prospect for immediate profit. And you know, similarly a mirror image pertains at bottom. The bottom, what people don't see is value. 1942, one of the great all-time give-away bargain sessions on Wall Street, the Japanese were knocking at the front door of Los Angeles and, evidently the capitalist was going to be destroyed by the totalitarianism that was then ascendant in the world, and so on.

So in 1942 you could have bought great American companies at dividend yields of seven and eight percent and borrowed money with which to buy them at two percent, or less. And people, you know, didn't do that because why? Well, because they knew that capitalism was on its uppers. they knew that the war would last forever. I mean what they thought they knew was that,, it was hopeless. And you know, 1996 is exactly the opposite of 1942 in a way. 1996 capitalism is triumphant and value will out and corporations will earn and so forth. Everything that people doubt at the bottom they now believe at the top. And it was ever thus.

Q Have you been watching the celebrification of fund managers? Has the horse race played a role in this excitement?

Red Smith, the late great sports writer relates that when he was on The Herald-Tribune, Stanley Woodward, the sports editor, said, "Look, don't God up the athletes. You know, let's keep them the mortal beings they are, not deify them." And similarly today in The Wall Street Journal it would be well if the editor would tell the reporters, "Listen, let's not, you know, canonize the portfolio managers."

However, but it is natural that this occurs at the top. A friend of mine, and a very conservative professional money manager, was startled recently to be requested by the perfect stranger to stand by and have his picture taken with this person because he ran a mutual fund. He'd never seen the likes of it before. So the process of treating people who manage money as celebrities, is a part of the process of making this huge top.

And the practical investment significance of this is that no professional can afford to not buy stocks, no matter what his or her opinion of the underlying value. Paradoxically, the most risk fraud assets for a professional money manager to buy is Treasury Bills. That's really the one class of asset that can get you fired. And it was not lost on anyone earlier in 1996 when the former star of the Fidelity Magellan Fund, Jeffrey Vinick made a bad guess and bought bonds and missed out on a truly wonderful levitation in the stock market and quickly had the epaulets of his celebrity stripped from his shoulders and left Magellan Fund. So these people are celebrities, but there's nothing more transient in Wall Street than celebrity. Nothing is more transient than financial celebrity.

Q What was October '87 about and what lessons?

October 1987 was a panic. And a panic is different than a crash. We can distinguish between the Crash of 1929 foreshadowed an economic event, namely, the Depression of 1929-33. ....In 1987 it was an architectural flaw; it was not an economic one. And I think the lesson that people learned from the October panic, October '97 -- '97 panic was to opportunistic and to buy. As soon as stocks go down a lot, buy them. This is a lesson that has been reinforced with every subsequent decline. The mini-crash of 1989, well, people bought and they weren't whole right away because they was a six-week bad patch in the fall of 1990.

The Gulf War, another splendid buying opportunity except for the people who were getting shot at, but on Wall Street it was a great buying opportunity. Similarly in 1994. What people have learned -- there's been a very important and deeply conditioned lesson in the past ten years. People have learned to buy every time that prices go down. Now it has not always been wise policy to do this, but for ten years it has been exactly the thing to do. Now it is a truism of Wall Street that every lesson is learned really well is going to be the wrong lesson. And it remains to be seen if now is the time not to have learned that lesson. But there's almost no lesson on Wall Street that you should learn and then remember always.

Q Isn't that what Merrill said in the '20s......

Far-sighted professionals in for the long term are in the business of buying and selling securities. And Charlie Merrill was exactly on the money when, in the 1920s-1930s, he said, "Stocks are meant to be bought and mostly held." But John J. Rascob was onto something in the summer of 1929 when he advised the readers of Ladies' Home Journal to buy stocks with a long pole, but he was wrong for 20 years before he was right again. I mean these decisions look great if you see them from the point of view of a century's perspective. But for those of us who live in the immediate present, meaning one- to five-year horizon, they can be dreadfully wrong and it wasn't for nothing that the taxi drivers in 1978 had sworn off common stocks. The short term can feel like an eternity when you're on the wrong side of it.

Q Talk about what's happened in the past couple of weeks.

My guess is that the stock market has peaked and it's heading down. However, if that sounds convincing, it's because I've had so much practice in saying it. (Laughs)

So I would not take that prediction or observation exactly to the bank, but I think what was most remarkable about the downturns of late spring and early summer of 1996 is that people were so upset by them. In the scheme of things, the middle week of July, 1996 was not much to worry about. And yet the powers that be, including The Wall Street Journal, the objective journalists of The Wall Street Journal, were out there telling people not to panic. Well, why were they beginning to panic in the first place? Is it because the price at which they had got recently invested were stupid prices? Well, yeah, I think so. So I can't help but be struck by the unanimity of the advice from the defenders of this bull market, including the press, namely, don't panic. It seems to me a little bit of measured and reasoned panic might be just the thing. (Laughs)

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