After a Lond Drive Down the East Coast

This series was inspired by vacation reading — Peter Bernstein’s AGAINST THE GODS. Anyone who is serious about investing should read it. Order it from Amazon…it needs the business.

This piece will be the last — I promise — in the series.

Charles Darwin’s cousin, John Galton, was fascinated by heredity. His illustrious family included far more great thinkers and achievers than mere chance would allow. Yet, when he studied the issue, he discovered that it was rare for greatness to persist in a family. A very accomplished parent would be likely to have children who were ordinary. This led him to the principle that we all know as “regression to the mean.”

It is the principle we are applying to the stock market when we expect prices to return “to normal.” But it has a couple of built in complexities. The most important of these is this — how can you know what’s normal? Much of life seems cyclical. The sun rises…it sets. Tides come in and then go out. Kondratief got sent to Siberia for finding long cycles in capitalism. But does human activity merely repeat itself over and over like the movie Groundhog Day?

Well…not exactly. In the 1960s …a new era began in US markets. The age-old relationship between stocks and bonds changed. Henceforth, people would be willing to accept stocks with dividends lower than the yield on bonds. This change was caused by another major change — the dollar was no longer backed by gold…and no longer a reliable store of value. Bonds were particularly susceptible to inflation…so people demanded higher yields.

This led a number of financial analysts — including many of my friends —to believe that things had changed in a much more fundamental way. They believed that the dollar would soon disappear…that gold would rise to almost infinite heights in dollar terms…and that bonds were merely “certificates of guaranteed confiscation.”

But the market is a very tough competitor. When you think you have it figured out…it does something unexpected. It reacts to efforts to understand it…and frustrates attempts to profit at above market rates. That is why winning strategies do not hold up over time. The Dogs of the Dow concept was hot in the 80s. Then, people began using it. They bid up the prices on the dogs to the point where the strategy would no longer work. In the five years from March ’89…funds focussed on international stocks went up 20%…the best performing sector. During the next 5 years they were worst. Seeing that it was almost impossible to beat the market, investors loaded up on index funds and Dow stocks. And now that strategy, too, no longer seems to be working.

Still, regression to the mean is a fact. Markets do not go up forever. Everyone can’t become infinitely rich. Trees do not grow to the sky. There are limits, in other words. And the further a system goes away from its apparent mean… or center…the more likely it becomes that it will reverse direction. At least…that is what I have always thought, intuitively.

If the direction of the market is completely random…and thus unpredictable…the pattern of up days and down days will follow the normal bell curve of random distribution. Two Baylor University professors plotted it out. Sure enough, they got a bell curve. In any given month, the odds that it will go up or down are little different than a coin toss (allowing for a slight upwards bias over time).

But there is something funny about this bell curve. When you look at both ends, you see that they have humps on them. This is not an ordinary bell curve, in other words, which feathers out to nothing at the extremes. This bell curve shows a lot of action at the extremes. Bernstein’s description:

“The chart of monthly changes does have a remarkable resemblance to a normal curve. But note the small number of large changes at the edges of the chart. A normal curve would not have those untidy bulges.”

I think we are on to something big here…something that analysts have not noticed. It is probably true that stock market timing is usually a waste of time. Most days, most months, most years, the market direction is simply unpredictable, like the toss of a coin. But when the market is either very underpriced or very overpriced…at the extremes…nature asserts itself with a powerful tug back to the mean. Thus, when he sees the market at an extreme, the prudent investor should adjust his portfolio in the expectation that the market will regress to the mean, however inexact that may be.

Here’s how Bernstein puts it, “At the extremes, the market is not a random walk. At the extremes, the market is more likely to destroy fortunes than to create them. The stock market is a risky place.”

Is the market at an extreme today? Or what?

Bill Bonner
August 1, 1999

This link will allow you to order Against the Gods from Amazon. http://www.amazon.com/exec/obido/ASIN/0471295639/o/qid=933598748/sr=2-1/002-4827533-7342427