Essential Matters

"We celebrate the beginning of Holy Week, with all its mysteries. But do not forget the essentials of Christ’s mission and his teachings. We don’t have to search high and low for them. He told us: Love God… and Love thy neighbor. That is what really matters."

Pere Marchand

Sunday’s sermon

"What really matters?" I asked our gardener on Saturday.

Mr. Deshais spends most of his time alone – working in the garden by himself. He has no computer screen in front of him – nor any CNBC or CNN to shape his thoughts. He has only himself – and the forces of nature: the clouds overhead, the soil, the plants. Mr. Deshais has time to think and not much more than his own thoughts to occupy his brain.

So, I decided to try out my new philosophy on him.

The Daily Reckoning sneaked into philosophical discussion over the last two weeks, dear reader – like a teenager who takes up smoking. We sputtered and coughed out existentialism, relativism and descriptivism. But just talking about them made us feel cool.

And so, without meaning to do so, we discovered a new side to ourselves – a new image… we became philosophers.

I am still out in the countryside – while the children enjoy a two-week vacation from school. No one south of the Loire nor west of the Hudson has any use for philosophy, but I can hardly wait to get back to Paris. Perhaps I will rub a little burnt umber on my fingers and cough occasionally… or even hold a hand-wrapped cigarette in my fingers… and jab at the surrounding air with it from time to time to make my point. Paris loves philosophers – the more obscure and ridiculous, the better.

I will make Le Paradis cafe my regular hangout, like Sartre at Le Dome. How perfect! People will know that I can be found there at almost any time of the day or night – a glass of wine in one hand… an unlit cigarette in the other. Besides, it’s close to the office so I can sneak away from time to time and do some work.

Oh, the philosophy itself… oh yes… that. Well, there’s the weak spot of this plan. My philosophy – which I share with you before releasing it to the public – has evolved from our insights about the stock market and how it works. Yes, this is probably the first major philosophy to sprout from financial advice – and probably the last!

Over the last year and a half, we have noticed:

1. Limitations of rational thought. We think we consider everything rationally and make decisions based on reason and available information – as the existentialists claim. But in fact, it is the heart, not the head, that is in command. The heart distorts logic and information to its own purposes. In short, we believe what we want to believe. "The head is merely the heart’s dupe," said La Rouchefoucauld.

2. An inability to look into the future. When you put a gun to your head and pull the trigger, the results are predictable. But in complex systems – such as an economy, a stock market, or an individual life – the future is unknowable.

I quote the celebrated economist, John Maynard Keynes, on this point (the Daily Reckoning is still a financial service, after all):

"The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory… amount to little and sometimes to nothing…"

– from The General Theory of Employment, Interest, and Money

3. Even the present and the past are largely unknowable. The world is awash with ‘information’ – so much that it is impossible to master it all. Instead, people pick and choose bits and pieces of information that suit their purposes. The new "Information Age" does nothing to change this. It merely increases the costs of getting rid of unwanted information.

4. The perversity of markets. Not only can you not know what the future holds, but attempting to figure it out actually distorts it! People searching for a Big Bottom in the stock market, for example, are unlikely to find it. Why? Because the Big Bottom only comes when people are so fed up with stocks that they stop looking for it.

5. The paradoxical and surprising nature of life itself: as I have said many times, investors don’t get what they expect, but what they deserve. This is true in the rest of life as well. Patience, modesty, hard work, greed, fear, hubris and other virtues & vices pay off. People get what they’ve got coming – usually. Even love comes not to those who seek it, or horde it, but to those who give it away freely. Life is full of surprises.

Many philosophies are founded on a ‘theory of knowledge.’ I take as my starting point a ‘theory of ignorance’: it is everywhere and in everything.

You know neither how your stocks nor how your marriage will work out. Most of what you hear is nonsense. Most of what you read is moronic. And most of the people you meet are fools. And most important: the people who meet you think the same of you as you do of them. And you’re both right! We’re all fools – and all completely ignorant of the things that matter most.

"The key thing," said Mr. Deshais, "is to get into sync with the phases of the moon. That’s the essential. If you ignore the moon when you plant your garden, you will not get a very good harvest. And if you graft your fruit trees on a new moon – you will get very good growth, but very little fruit."

The key to the new philosophy of Essentialism: whatever you are doing, find the key principles, the rules, the essentials – and stick with them. More on Essentialism on another slow news day.

Your essential essentialist,

Bill Bonner
March 25, 2002 — En route to Spain

P.S. Alas, my new philosophy is too sensible. It will never catch on.

Bill has taken an early flight this morning to the land of Don Quijote, sangria, and tortilla. But assuming the cultural splendors of Madrid don’t convince him otherwise (translation, if he wakes up from his siesta in time to catch his flight), Bill should be back soon with the kind of fresh insights and satire that Cervantes might have appreciated. So after checking in with Eric in New York, you’ll find below a DR classique that we think is particularly appropriate for today.

Eric… did the market’s matadors slay any bulls today?

********

Eric Fry on Wall Street…

– The bulls cut out for spring break early last week, leaving the stock market at the mercy of the bears. All the major indices lost ground over the five-day stretch.

– "The market spent the past week in a sulk," writes Smartmoney.com’s Igor Greenwald. "The Dow’s 180-point dip may not mark a 180-degree turn from the recent rally, but neither does it suggest a deep reservoir of optimism about the future."

– By falling 1.7% on the week, the Dow snapped a 5-week winning streak during which the blue chip index soared nearly 1,000 points. After such a breathtaking run-up, the bulls deserve a little R&R.

– "It is not man’s power of reason that fails," Bill wrote last week, "but his power of imagination. He cannot imagine what will go wrong – until it does."

– Bill may well be right. On the other hand, it is possible that investors suffer from too much imagination, rather than too little.

– They are able to imagine, for example, that stocks selling for 40 times earnings offer an exciting investment opportunity. Even if I closed my eyes and tried real hard, I don’t think I could dream up a story like that. Perhaps I am simply too earthbound to be capable of such flights of fancy.

– Most investors also imagine that a yawning current account deficit poses no threat to the U.S. dollar. And they can easily imagine that U.S. productivity is growing by leaps and bounds, that inflation is "well contained," that Greenspan is in control of the economy, that Enron was "an isolated incident," and that Abby Joseph Cohen’s market forecast are more trustworthy than a coin toss.

– Investors also seem to have no trouble imagining that CEOs and CFOs of public companies are "basically honest."

– Just because these fanciful notions might be self-delusional, does that make them any less imaginative?

– We literal, and somewhat brutish, investors see a stock market that is rising, even though it is richly valued and even though corporate profit growth is likely to be anemic. We simply cannot imagine that this story will have a happy ending. As we see it, the U.S. stock market is not a solid long-term buy, but a likely long- term sell. At best, it enjoys no room for error.

– A market this richly priced lacks what the legendary value investors, Graham and Dodd used to call, "a margin of safety." Then again, consider the source. These two guys were pretty darn boring… and completely without imagination.

– So just how overvalued is the stock market anyway? And why are we at the Daily Reckoning always whining about how expensive stocks are? Let’s turn to the experts for the answer. Three long-time market observers weighed in recently with their assessment of the market’s value… or lack thereof.

– Paul Macrae Montgomery of Baltimore’s own Legg Mason, points out that the P/E ratio of the median ValueLine stock stands at 20.3 times, a new record high and well above the 20-year median of 14.3 times.

– Next up, Charles Biderman of Liquidity Trim Tabs remarks, "There is little question that the top three favorite NASDAQ stocks are still Microsoft, with a $338 billion market cap, Intel with a $213 billion market cap, and now the poor sister, Cisco, with a $121 billion market cap. The big three combined market cap of $672 billion equals 24% of all NASDAQ stocks and more than half the NASDAQ 100. Intel, historically subject to wide earnings and sales swings as the economy waxes and wanes, is a cyclical stock priced like a growth stock – now selling at 46 times estimated earnings while revenues have been plunging… [Cisco’s] P/E ratio is still a frothy 51."

– Lastly, the Leuthold Group considers stocks very richly valued based upon its proprietary number- crunching methodology. "The Leuthold Group (which, by the way, is bullish on stocks) provides the fairest deconstructed valuation data," Jim Grant observed recently. "It adjusts and normalizes earnings per share my using a five-year arithmetic average (12 months ahead and 48 months back). It surveys the data from 1926, weeding out the high inflation years, and it finds that the S&P changes hands today at 24.4 times earnings, against an historical median of 18.6 times.

– "For good measure, Leuthold also examines the dividend yield, price to book value and price to cash flow, and it combines them with P/Es. It reports that, to return to median evaluations (low inflation years only), the S&P would have to decline by 34%."

– Sure, the market might seem expensive, but just imagine what a terrific bull market we would have if the S&P 500 traded up to 75 times earnings!