A New Paradigm For The New Century: Published January 22, 2000 (Bitcoin is the pin not the bubble)

As the new century dawns, it seems to many people that the old rules of investing are forgotten as if they were obsolete. Have the earnings (or lack of them) behind a stock really become irrelevant? In this article, Paul Merriman addresses this and other issues that are on many people's minds these days.

by Paul A. Merriman

"The day after Christmas, the Washington Post proclaimed "a sea change in the investing culture of America" as day trading (a clever euphemism for gambling) is regarded as a profession and money-losing companies are revered while profitable enterprises are scorned.

The U.S. stock market has just finished five years of its greatest bull run in history, and there seems to be no end in sight. These gains are helping to fuel what the Conference Board reported as the highest level of consumer confidence in 31 years.

Some of us who have been in the investment business for a while think things are really out of hand. And many old hands simply can't figure it out, because the raging bull market is ignoring all the old rules that we learned.

In mid-November, the Nasdaq Composite Index went through the 3,000 mark for the first time. By the end of December, the technology-heavy index was above 4,000. Money continued to pour into technology and Internet stocks at a torrid pace, and market observers have no clue about when the flow will dry up.

Here are some interesting quotes I found in the media during the last week of 1999:

"Five years ago, you?d see a 1 percent move (in the Nasdaq index) every two weeks. Now you see a 1 percent move almost every day."

-- Portfolio manager quoted in The New York Times

"I don?t know what to make of it in a larger context because there is no larger context to fix it within. I look back at the past manias' whether the bowling stocks of the early 60s, the tech stocks of the 1970s or the airlines of 1990's and rarely has such a move been mounted without some support from the broader market."

-- John Bollinger, president of EquityTrader.com and a student of market history, quoted on TheStreet.com

"I'm totally baffled by this market. Everybody's chasing the same dozen stocks. I've never seen it this bad, and I've been in the business for 46 years."

-- Stanley Nabi, chief investment officer at DLJ Investment Management, quoted on TheStreet.com

"My wife has a hard time with how this is different from gambling. I can't really give her a good reason. We're all standing at a giant craps table."

-- An individual investor quoted in USA Today

There's no question we're in a new year and, despite those who (correctly) protest that the millennium actually starts in 2001, in the popular mind we're in a new century. Are we in a new economy? Are there new rules that make the old ones obsolete? When Time Magazine names Jeff Bezos, founder of Amazon.com, as the man of the year, one has to wonder. Bezos is brilliant at marketing, fund-raising, devising a new concept and executing it better than anyone else. But his company has yet to make a dime of profit. This is an exemplary businessman?

In the restaurant business, they say that people pay for the sizzle, not the steak. In the stock business, people pay for concepts, not earnings. It's easy to understand the lure of technology stocks. Technology is dramatically, rapidly changing the way we interact with each other and with the world. And tech stocks, at least many of the big ones, have provided enormous rewards for investors. The best U.S. stock of the 1990s, Dell Computer, returned a compound rate of return of more than 90 percent. That's return per year, for a whole decade.

At recent investment conferences, investors have started telling me they have concluded they don't need mutual funds, and they don't need diversification. They have decided they would rather buy 10 to 20 individual stocks, almost always ones with dazzling performance in the very recent past, and in effect create their own personalized "focus funds." I just hope they aren't staking their life savings on this strategy.

When I ask Baby Boomers traditional questions about valuations and risks and earnings, they don't know the answers. And they don't care that they don't know. They are used to being rewarded for taking big risks without the burden of knowing a lot of facts. (I am amused by the stories that pop up occasionally of online investors, who trade from their keyboards without ever talking to a broker, so eager to place their buy orders that they use the wrong ticker symbols and wind up buying stocks they have never heard of.)

What's new about this market is not that some investments have skyrocketed, but that so many people have participated in it. The "everybody is winning" attitude breeds sloppiness. When investors behave as if risk is irrelevant, they are in grave danger and so are their families unless they are just investing with "mad money" that can be lost without serious consequences.

One of the most obvious and most widely quoted rules of investing is "Buy low, sell high." But many investors have stopped doing that. Instead, they've learned that they can make money by following a new rule of thumb: "Buy high, sell higher." By this reasoning, the farther a technology stock goes up, the better buy it is. That defies logic, but that hasn't stopped eager investors from pouring billions of dollars into these stocks.

The way to consistently buy low and sell high is through value investing, the discipline of buying out-of-favor companies. But it seems to be largely abandoned. Why? Mainly because it's not been "working" lately. Despite what you might think, the majority of stocks traded on the New York Stock Exchange actually lost money last year, even as the popular indexes were setting new records.

One thing that worries me: What happens when investors conclude that the Nasdaq and the Standard & Poor's 500 Index have also "stopped working?" Will they abandon stocks altogether?

A second thing that worries me: Many veteran money managers are very nervous about the market, but they are reluctant to talk about it publicly. If you sound too scary, they believe, investors will take their money elsewhere, close their accounts, cancel their subscriptions. People want hope and encouragement, not warnings. And in this business, like most businesses, you are rewarded for telling the customers what they want to hear which is not always the same as what those customers need to hear.

Maybe each new generation must learn the facts of life the hard way. But to those of us who have been around for decades, the great bull market of the late 90s seems familiar in some ways. We've seen merger manias before, and we've watched them crash and burn. We've seen "concepts" take the place of profits, and we've watched investors lose their shirts. This is not the first time we have seen corporate officers and directors get the spoils and leave shareholders holding the bag.

I could go on and on, and some readers might conclude these are the ravings of an old guy who just can't adjust to the way things are now. I'll accept that risk, but let's look at where you fit into the picture.

As an investor, you have a choice. On the one hand, you can ignore all of history and charge full-speed ahead into the "new paradigm." You can bet your life savings that Internet and telecommunications stocks will make your fortune.

On the other hand, you can learn from history and recognize that never before has a huge speculative bubble produced lasting, permanent returns. You can embrace the "old" rules of investing, even if that means you have to stay partly or completely on the sidelines while others rake in huge profits. Those old rules include diversification, fundamental analysis (knowing, for instance, that profits mean more to a business than a "concept,"), prudence and patience. You may choose to have part of your portfolio in hot equity funds, but you'll recognize that what's hot today can turn mighty cold, mighty fast. Thus, you'll limit your red-hot investments to some appropriate percentage of your portfolio.

I'm not going to tell you which course you should follow. Only you can decide which consequences you want to take. But I'm about to take the risk of alienating readers who are hell-bent on investing in concept stocks, and telling them what they don't want to hear.

Any savvy investor should know about something I was taught very early in my career, back in 1966. The market has changed a lot since then. But human nature hasn?t changed, and this item is just as valid as it ever was. And it might give you some perspective on the current market.

You may already be familiar with this piece of wisdom, which is commonly known as the "greater fool" theory. As a neophyte stock broker, I was taught various selling techniques. We were taught about "hot" stocks, ones that often didn't have any earnings behind them, and about which neither we nor the clients knew enough to have much confidence.

"You would be a fool to recommend a stock like that, and your client would be a fool to buy it," we were told. "But don't worry, because you and your client will do fine as long as you can find an even greater fool to buy that stock at a higher price later."

In other words, you don't have to rely on the stock or the company behind it, just rely on human nature, namely greed. Eventually, the supply of "greater fools" will dry up, leaving somebody holding the bag, the last fool in the chain. Ouch!

I don't mean to suggest that investors who buy Internet and telecommunications stocks are fools. Undoubtedly some of these companies have very bright, profitable futures ahead of them. But I think some investors are relying on the "greater fool" theory without realizing it. And they may live to regret it.

If you believe the "greater fool" theory is still valid and that it could apply to technology stocks that have no profits or even any plans for profits, then you have to factor it somehow into your decision to invest in such stocks, either directly or through mutual funds. Logically, you have a choice to either ignore this theory or decide that it doesn't apply, or to think that you can work it to your advantage. You do that by assuming that you won't be the last fool in the chain.

Either approach is very risky, in my view. If you think the greater fool theory doesn't apply, and if you think there's wisdom behind the high prices of these no-earnings stocks, then I can't help you any more except to wish you luck and hope you are doing this investing with only part of your portfolio.

If on the other hand you grant that you may be just one of the fools on a chain, and you are confident you can sell to a greater fool, in other words if you believe you can work this theory to your advantage and not wind up as road kill, then I ask you to think about how you will know when you're approaching the end of the line in the chain of fools. How will you know when to bail out and leave the rest of the action to the greater fools?

If you're doubling or tripling your money every year (that's the unlikely fantasy that drives a lot of these stock purchases), it will probably look like there's an endless supply of "future fools" to keep driving the prices up. How will you know when to jump off the bandwagon?

I don't know how to make those decisions, and I predict that you'll have to struggle with them.

I can't find any historical example where such excesses lasted for the long term. In short, there's no road map into the future.

If you choose to believe that history is relevant, you'll have to notice that price/earnings ratios are at historic highs, dividend levels are extremely low (and some companies have decided they don't need to pay dividends any more to attract investors) and that bond yields are starting to look attractive, compared with after-tax and after-inflation corporate earnings. All those facts point to a market that in general is overpriced.

The "new paradigm" theory holds that today's stocks should not be judged by yesterday's standards. But this is the same story I have been hearing in this industry since the 1960s. The brokerage houses sell to the path of least resistance, because that's what works. They may be pretty sure that the whole thing is a house of cards that will collapse, but their responsibility is to keep doing deals, such as initial public offerings, that make money for corporate insiders. (More than 540 IPOs last year raised more than $100 billion.)

I don't believe we are in a new paradigm. This may sound harsh, but I believe investors are being misled by recent exuberant optimism, irrational expectations, and unrestrained greed.

The problem with sky-high returns is that they blind investors. When you are blind, you can't see what's obvious. One thing that's obvious to me is that most people really hate to suffer losses. And when you invest in no-profit concept stocks, your chances of experiencing loss is very high. The good feelings you get from making $100 of profit are nothing compared with the bad feelings you get from losing $100.

In the short run, sky-high returns give investors rewards for taking risks and for ignoring the fact that risk means loss. In the long run, this encourages counterproductive behavior on the part of investors.

Proponents of a new paradigm apparently believe the greater fool theory no longer applies, and that it's reasonable to pay very high premiums in order to buy popular assets, without relying on some greater fool in the future.

Success is intoxicating in the short-term. But a party that never seems to end is a party that goes stale. And this party is not being held for the benefit of investors. It's being held for brokers, corporate officers and directors, software programmers and others who are fortunate enough to acquire lucrative stock options. The shareholders are the ones who pay for it all. At some point, those shareholders will stop paying. And the last ones who have paid will be among the greatest fools.

So the important question is: How do you keep from being one of those greatest fools?

Some money managers don't know how to deal with the runaway bull market. But we do.

We believe serious investors should devise long-term investment plans that don't rely for their success on short-term bursts of market excesses. Investors who use market-timing should stick to their systems, and use their discipline to protect against the coming bear market, which we regard as not quite inevitable but highly likely.

Investors who don't use timing should make sure their portfolios include enough fixed-income investments to moderate the volatility of stocks.

Most investors should have at least some equities in their portfolios to take advantage of the growth in technology, medicine and telecommunications that is likely to fuel economic activity in this new century.

All equity investors should practice wide diversification. That means including international stocks as well as domestic, small-cap stocks as well as large-cap ones and value stocks as well as growth stocks.

Finally, investors who have a high desire to participate in the "new paradigm" (or whatever it really is) should limit their risky stock investments to some set part of their portfolios. The percentages will vary widely, depending on each investor's age and circumstances. But nobody should bet his or her entire future on stocks that have no profits."

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