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The Stock Market - A Game of Chance

(April 12, 2004)

Dear Readers:

I have chosen to take a different route in approaching this particular commentary.  Recall the writing frequency of the great Dow Theorist (and the fourth editor of the Wall Street Journal), William P. Hamilton - sometimes, he would write nothing about the stock market for weeks on end simply because there was nothing new to add to his previous editorial.  I currently feel the same way.  I still believe we are in a major bull swing, which will most probably not top out until September 2004 to May 2005 at the earliest.  The action of the stock market during the last several weeks has confirmed my beliefs (please read my earlier commentary for my previous analyses).

I intend to write a more general commentary about stock market investment and speculation.  I am also planning to express my opinion about the current state of the U.S. bond markets in my next commentary, but since I have not developed an expertise in bonds, readers may want to treat my opinion in this field as a "mere guess" and use it as a springboard to do more independent research on their own.

As I pointed out in my last commentary, being able to successfully trade or invest in the stock market requires an objective gauging of the probabilities and determining the best position to take based on what one has evaluated from these probabilities.  In other words, it is a game of chance - a game which is played by the most intelligent and hard-working capitalists around the world, a game which is not always fair, and a game, if it is not a zero sum game, is very close to it.  Under most circumstances, the average American will choose not to play in this type of game.  He or she would have much better odds in Vegas, and the classic quote is that you are at least being entertained while you are losing your money.  In the stock market, you get no such thing.  The only reconciliation you will get is that all your friends are losing money at the same as you are.

So why do Americans choose to play?  Why does the average American think he or she can earn an extraordinary return (anything over the risk-free rate) in the stock market without putting in any extra study or effort?  I do not know the answer.  Maybe it is the propaganda we are getting from the popular media.  Or maybe it is the mad-scientist academic theories being spewed out of Ivy League professors who have no right to comment in the stock market in the first place, such as the "random walk theory," "efficient market hypothesis," or trash such as "Stocks for the Long Run" by Jeremy Siegel.  These are the same arrogant, overrated people who do not have the capability of making any meaningful money in the stock market and instead of admitting their own faults, they simply state that it could not be done and anyone who has done it is merely lucky - totally contrary to the teachings of Benjamin Graham (which I believe in).  Is Warren Buffet lucky?  How about George Soros - who amassed a fortune of over $8 billion during 40 years in speculating and investing in the financial markets?  Or Steve Cohen - who chalked up an annualized return of over 80% during this 15-year streak ending 2002 in his hedge fund and is in the Forbes Top 400 List?  I do not think so.  Then there is Sir John Templeton, Paul Tudor Jones, Richard Dennis, Stan Weinstein, Jim Rogers, and Peter Lynch - the list goes on.

Unlike the game of life, where there are win-win situations, there can be no such situations in the stock market.  Most people will lose money in the stock market over their lifetimes.  I stated this axiom (and it is an axiom) back in January 2000, when I pleaded my friends and associates to sell all their stocks and mutual funds in their investment portfolios.  Virtually no one believed that at the time (which made me more confident since the top of a bull market is meant to suck everyone in and make them stay in before the ultimate crash), and I hope more people believe in that today.  Still don't believe it?  Talk to me again in ten years and we will see.

It is an axiom that the majority of the public will ultimately lose money in the stock market.  It has to be because most of the money from the public does not come in until the tail-end of the bull market, and conversely, a bear market cannot end until the majority of the public has sold all their stocks.  History has proved that this is the case.  After all, who was holding stocks at the bottom in July 1932, when the Dow Industrials was trading at 41 and when the dividend yield was over 10% (compared to just 1.6% today)?  The fact that it was trading at 41 (an 89% decline from its top of 381 on September 3, 1929) meant that probably besides the Rockefellers and the Morgans, no one else could have been in the stock market at that time.  They either panicked or had to sell their stocks because they had lost their jobs and needed the money to feed their families.  It was the best buying opportunity of a lifetime, but no one could take advantage of it because they either did not have the money or were too scared to get in (keep in mind that the ultimate bottom came on the day the Bonus Army marched onto Washington and in the midst of an unemployment rate of over 25% -- democracy and capitalism was thought to be in danger at that time).  Back then, cash was definitely king.  Professors like Jeremy Siegel do not take this into account, and I doubt he would be holding or buying any stocks himself if he was alive at that time.  Finally, up until the mid 1950s, being a "prudent investor" meant that you could not have ANY of your portfolios in common stocks.  Even if a fiduciary of a huge estate or a pension fund recognized the value in common stocks in 1932, 1942, or 1949, he would not have been allowed to allocate even one penny into a blue-chip common stock such as AT&T (it was simply known as TELEPHONE back then), which was yielding a huge 12% at the bottom in July 1932.  The following chart of the Dow Industrials during that fateful period illustrates this perfectly - so much for holding stocks "for the long run."  When push comes to shove, your average retail investor (I define this as anyone with less than a million dollars in financial assets today) does not stand a chance.

Dow Jones Industrial (June 1929 to May 1933)

Fast forward to December 1974.  The Dow Industrials smashes to a new 12-year low of 577.60.  Gold crosses $197 in Paris in April, after trading at $35 an ounce only six years earlier.  The prime rate surges to 11.5% in May, the highest in U.S. history.  Richard Nixon resigns as President in August, and Franklin National Bank collapses in October, which was the biggest bank failure in history at the time.  New car sales were down 34%, and housing starts slumps to an eight-year low in December.  The unemployment would skyrocket from 4.6% to 9% over a 19-month period ending in May 1975.  The U.S. slides into the worst recession since the 1930s.  Who in their right mind would buy stocks?  And yet, this was again a buying opportunity of a lifetime.  In his special report mailed on December 20, 1974 to his subscribers, Richard Russell, the last living great Dow Theorist, stated:

Now this is how I view it.  I think the odds are probably better than 50/ 50 that the Dow and most shares hit a bottom in December, 1974.  I put this thesis together with a number of other facts.  As you will see in a later section, the unweighted NYSE average is now down around 77% from the high.  In 1929-32 the unweighted NYSE average went 12% further on the downside - to an 89% loss.  I feel that most shares have now discounted all the forthcoming bad news, and I am including recession-depression conditions in 1975. We have been in the third phase of a great primary bear market.  We are finally in the zone of "great values".  In many cases, stocks are selling "below known values".

Here's an interesting statistic: The price/ earnings ratio for the 30-Dow Industrials is now around 6.0 while the yield on the Dow is 6.36.  This means that the Dow P/E is below the yield on the Dow.  This happened only once before in the last forty years, and that was during 1948-50.  Second item: The Dow is now selling below its book (or break-up) value.  This has not occurred since 1942.  Are these two above Dow "tests" infallible indications of the final bottom? Not at all, but they do indicate that the Dow is sure getting down there.

The frightening two-year decline of the stock market and the consistent pessimistic economic and political news during that period caused a great washout of speculators and retail investors alike - creating a stock market bottom unlike anything seen since 1949 (when the Dow Industrials traded at 161).  Richard Russell, in his special report, ignored all the mass emotions and pessimism that were prevalent at the time, and came up with a cold-blooded, objective analysis that would rank as one of the greatest calls in stock market history.  Peter Brimelow, a regular writer on, recalled what the general sentiment was at that time in this article, stating: "Russell rises to extreme occasions. I am old enough to remember stunned silence in the newsroom of the old Toronto Financial Post (we still used typewriters) when the news editor, a Russell subscriber, suddenly yelled out that Russell had turned bullish -- right at the bottom in 1974."  Russell himself hesitated even as he was buying blue chip stocks such as Exxon and Texaco, figuring that even if they declined another 20%, at least the 10% dividend yield would make up for the loss over the next two years.  The following chart illustrates the action of the Dow Industrials over the 1966 to 1974 bear market, with a special emphasis on the CPI-deflated Dow Industrials since the U.S. was experiencing relatively high inflation during that time:

Dow Industrials vs. CPI-Deflated Dow Industrials (January 1966 to December 1975)

Again, the question to ask is: would you or would the average American have held on or bought stocks at that time?  I have no doubt that Russell's subscribers were men of above average intelligence, and with above average market savvy.  His list of subscribers included CEOs of Fortune 500 corporations, editors of financial papers, hedge fund managers, and even the Bank of China.  Most of these individuals are the greatest capitalists and industrialists of our time.  Combined with the objective and cold-blooded nature of Russell's analysis, you'd think that most of his subscribers would have taken advantage of this once-in-a-lifetime buying opportunity.  And yet, this was not the case.  Numerous subscribers actually cancelled their subscriptions thinking Russell has clearly gone out of his mind (the same situation happened when he declared a top in the stock market in September 1999 - four months before the top in the Dow Industrials and six months before the top in the NASDAQ).  Other subscribers sent him viscous letters.  All in all, few people took advantage of that buying opportunity, and ironically, that is the way major bottoms are made.  Once again, I do not think the average American even had a chance.

My personal favorite illustration is the top in the NASDAQ during March 2000.  It is a personal favorite of mine because I recognized the top through independent research and I personally profit from it, along with being able to get some of my friends and associates out of stocks during that time.  In a series of emails which I sent to friends and associates (February 14, 2000, March 5, 2000, and finally April 2, 2000 - a mere two days before the 15% intraday plunge in the NASDAQ), I detailed the comparison between the days leading into the top compared to the period leading into September 1929, and the financial "frauds" that were going on in various companies, namely stock options expensing (or the lack thereof) and other aggressive accounting strategies.  I talked about the use of the term "new era" (which was also used in the 1920s and 1960s), the immense overvaluation in the NASDAQ (not witnessed since probably the Mississippi/South Seas Bubble in France/England in 1719 and the 1720s, or other words, things were much more overvalued than in 1929), the topping out of the NYSE Advance-Decline Line TWO YEARS before the ultimate top, huge increases in margin debt, "widows and orphans" getting into the stock market, the Fed raising the Fed Funds Rate to cool down the stock market, and the fact that the NASDAQ was trading at FOUR STANDARD DEVIATIONS above its 200-day moving average at one point.  I studied the NY Times headlines and articles and the daily closing prices of various stocks in 1929, and I was so sure at one point that I used the money in my entire portfolio (I sold out of all my tech stocks in January 2000) to buy put options in stocks such as Cisco, Intel, and Oracle.  I made 150% of my money over a three-month period.  That was in my younger days, and I would never do anything like this again today.

What literally sent me over the edge at the point in time was irrefutable evidence that the last bear was getting sucked into the stock market.  People who have never invested in stocks before came to me and asked me what technology stocks I liked.  People who have put all their money in CDs for most of their adult lives started to put into money into tech stocks and funds.  Even my conservative grandfather (God bless him), who have been through a depression, a world war, bank collapses, and numerous recessions asked me to open a stock account for him towards the top.  I did, but I shorted stocks for him instead.  At one point after the initial crash in April, he thought that I had lost his "play money."  I am glad to say that just before he passed away in November of last year, the cumulative appreciation on his account was approximately 150% before we closed it.

But enough - my initial point is that investing or speculating successfully in the stock market means that one needs to be able to objectively gauge the various probabilities and make a rational decision from that objective and cold-blooded analysis.  Can the average American do it?  Most probably not, as history has proved.  Even if the average American can make this objective and cold-blooded analysis, he would not be able to make money in the stock market over his lifetime, since the stock market is very close to (if is not) a zero sum game.  The insiders, investment bankers, the brokers, and the mutual fund managers will always get their share - what is left for the public?  And let's face it, the average American is also too lazy to do any analysis - preferring to spend his time watching sports or playing video games instead.  Why they could spend eight hours a day at work, five days a week, and not be able to spend even two hours each week to work on his retirement is beyond my comprehension.  Why does one think that by blindly holding the S&P 500 can one achieve extraordinary returns - that is, anything over the risk-free rate over a certain number of years?  To even think one can do that without putting in the work, the study, and the historical analysis is an INSULT to all the great investors and speculators who have come before us.  Some sixty years ago, the great speculator Jesse Livermore had this to write in response to strangers who come up to ask him how they can make money in the stock market: "It is difficult to exercise patience with such people.  In the first place, the inquiry is not a compliment to the man who has made a scientific study of investment and speculation.  It would be as fair for the layman to ask an attorney or a surgeon: "How can I make some quick money in law or surgery?""

Livermore would lock himself in the main vault of the Chase Manhattan Bank in New York for three nights and two days straight right before New Year's every year to review all his trades for the past year.  Can the average American make this sacrifice?  Probably not.

Again, the stock market is a game of chance.  But it is a game of chance where you can tilt the probabilities higher in your favor, if you put in the time and effort and if you know what you are doing and can do it objectively.  Just like anything else in life, if you follow the crowd or if you want to fit in, or if you get your financial advice from CNBC, you will get burned.  If the people who are giving financial advice are so great at it, why do they still have a day job, or why are they not multi-millionaire professors?  Why are all these CFA charter holders not sitting on some beach and having a grand old time?  I will tell you why.  Because they do not know anything about the game of investing nor speculation.  In fact, getting an MBA is the worst thing you can do to yourself when it comes to investing, since the people who are teaching you never succeeded in that field (unless you attended Columbia when Jim Rogers was teaching there for a brief period of time), and you are supposed to look up to them.  If they did not succeed, why could you?  They have not bothered to study financial history.  They have no firm grasp of the big picture.  They do not know nor care what technical analysis is and they were the ones who chose to hold stocks such as Enron, Worldcom, and Global Crossing all the way to zero because they had no idea (or was too arrogant to care) what a stop loss is.  The ones that are somewhat knowledgable tell the clients what they want to hear, and do not want to "rock the boat" so they did not buy Microsoft or Dell at their early stages, but instead bought stuff such as Bethelem Steel and Montgomery Ward because it was the popular thing to do back then.

A quick and objective analysis involves looking at the following chart which I have posted before on my site:

SP500 P/E Ratio 1943-2002

Please note the huge buying opportunities in 1949, 1974, 1980, and 1982.  Since October 2002, the P/E ratio for the S&P 500 has stood at around 30.  Given the historical precedent, can one objectively and honestly state that the chances of actually making money in the stock market going forward is low, medium, or high?  Let's also assume the average American will not be shorting stocks.  If you need to, please turn off the TV and lock yourself in a quiet space without any newspapers and think about this over a weekend.

At this point, some people may be asking: "What about bonds?  Surely if I have a good mix of bonds and stocks, I should be all right?"  My answer is the same.  You need to put in the time and effort to study both markets if you do.  You are probably better off just focusing on one market (I would recommend the stock market in this case) and investing all your "eggs in one basket."  In the book "Triumph of the Optimists," a book which Bill Gross of the Pimco Fund (Bill Gross manages the biggest mutual fund with over $50 billion in assets) often likes to cite from, the authors did a exhaustive and thorough study of bond returns around the world in the 20th century.  The authors noted that there were two secular bull and two secular bear markets in U.S. bonds during that time.  The first bull market lasted from 1920 to the early 1940s, just before the U.S. entered the Second World War.  The subsequent bear market in bonds lasted more than 40 years, and if you had held a portfolio of long-maturity (about 20 years or so) U.S.government bonds and did not sell during that time, your real annualized return would have been approximately NEGATIVE 0.22%!  If you had bought your portfolio of long-maturity government bonds in 1900 and held them until the early 1980s (a period of over 80 years), your real annualized return during that period would have been a grand total of 0%.  Since the early 1980s, we have had a huge bull market in bonds, with a portfolio of long-maturity government bonds returning a real cumluative return of 500% up to the year 2000.  This is definitely an outliner, and I expect the bond market to be entering a bear market (if it has not so already) very soon.  I will go into more detail in my next commentary but to put it briefly, I now believe we are in the middle of a secular bear market both in stocks and in bonds.  For those who think you are safe in bonds if the stock market collapses again, please think again.  In fact, I think the bond market will actually serve as a warning shot to the stock market and so will actually collapse before the current rally in the stock market ends.  It is not going to be pretty going forward.

To conclude, I would say this: Please keep in mind that Wall Street is basically a huge sales force, and sales people generally do not care much about their merchandise once they have sold or auctioned them off.  If you really want sound financial advice, please know where you are getting the advice from.  Read the works about Warren Buffet, George Soros, Jim Rogers, Sir John Templeton, Jesse Livermore, and Peter Lynch.  Read what they have to say (of course, the ones that are still alive) in current articles.  I believe my views confirm with theirs.  If you want sound advice about your career, find a mentor that has been there and is very successful at what he or she is currently doing.  It is beyond my comprehension - most people search for advice in all the wrong places when there are so many credible resources out there who are willing to help you.  My only logical explanation to all this is that most people don't really look for or want real advice - they just want other people to reaffirm what they are doing is correct and most of them will never try to change their ways or admit their own faults.  This is another reason why most people will keep on making the same mistakes and never succeed in making money in the stock market.

Signing off,

Henry K. To, CFA

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