THE WALL STREET SELF-DEFENSE MANUAL

Introducing New Blog...Investment Intelligencer

Thanks for your interest in the Wall Street Self-Defense Manual.  This site contains more information about the book, including excerpts, the table of contents, and a welcome note.  It also contains links to other investing books and resources that I hope you'll find helpful.

I will continue to post additional book excerpts here for the next several months, and I will leave the site up indefinitely.  As of today, however, I am going to post additional market and investing commentary on a new site, Investment Intelligencer (www.investmentintelligencer.com).  Like the book, the site is designed for intelligent investors, and it will draw on smart ideas from academia, Wall Street, and the financial media.  It will pick up on many of the themes I discuss in the book, and it will also include analysis of some important fundamental issues.

Thanks again for visiting the site.  I hope you enjoy the Wall Street Self-Defense Manual, and I hope to see you over on Investment Intelligencer.

A Pretty Feeble "Rebound"

After living through one market meltdown (in which I had prime seat at the table), I don't think it is possible to predict whether yesterday's collapse is a harbinger of doom or just a sharp reminder that markets don't always go up.  Despite what they'll tell you now, almost no one predicted the 2000-2002 debacle; on the contrary, for the first 6 months of the downturn, the majority of folks (including yours truly), thought the sell-off was just another in a long series of "corrections" that the market had experienced almost every year in the latter half of the 90s.  It wasn't until late 2002, when even the S&P had been cut in half, that it was widely agreed that this was it--the big one.  (And that agreement, of course, was a hint that it was a wonderful time to buy).

So the bottom line about all this musing about "what yesterday's sell-off means" is "no one knows."  That said, using cyclically adjusted valuation measures (those that take into account today's record-high profit margins--see Grantham below), the market is still significantly overvalued, and that condition will probably correct itself eventually.  I'm also not sure why today's 50-point rally has triggered relieved headlines about a "rebound."  If yesterday's panic really was just a momentary flinch after Shanghai and we really are off to the races again, one might have expected to see a bit more universal enthusiasm.

New GMO Market Forecasts: Stock Investors Are Screwed

The methodologies underlying most market forecasts do not actually have much predictive value, and as a result, their predictions are no better than the standard market odds (and in many cases worse).  What are these odds?  To pick one example, the odds that the S&P 500 will go up over any given year are about 2-in-3.

One firm that produces forecasts using a thoughtful, defensible methodology is Boston's GMO.  The firm makes no claim about being able to predict performance over short and intermediate-term timeframes (Chairman Jeremy Grantham's recent foray into "Presidential Cycle" forecasts produced a few bad calls, so he sinced returned to his valuation-based knitting).  Instead, it estimates the likely performance of a half-dozen major assets over a seven-year period. 

Unlike most firms, GMO takes into account the business cycle, "normalizing" today's record-high profit margins under the theory that they will eventually regress to the mean.  (If they don't, Grantham is fond of saying, capitalism is broken.)  Work by Andrew Smithers of London-based Smithers & Co. has shown that such "cyclically-adjusted" analyses have predictive value, while those that look at a single year's earnings in isolation don't.  The one caveat (there's always at least one) is that this valuation metholody depends on mean-reversion.  On the rare occasion when things are, in fact, "different this time," it doesn't work.

In any case, GMO recently published its asset-class forecasts based on prices at the end of January.  For those who like their bad news delivered graphically, GMO's own publication is vivid.  For those who prefer text, here's a snapshot:

Real Seven-Year Asset Class Return Forecasts (Expected annual return over 7 years. Source: GMO)

U.S. Equities (Large cap):  -1.7%

U.S. Equities (Small cap):    -2.6%

Int'l Equities (Large cap):     -0.3%

Int'l Equities (Small cap):     -2.3%

Emerging Equities:              +1.6%  (Hallelujah)

U.S. Treasury Bonds:            +2.0%

The bottom line?  Unless you can limit your equity exposure to "high-quality" stocks, GMO expects you'll lose ground to bonds.