Gary Kaminsky is the cohost of CNBC’s “The Strategy Session” and has been one of Wall Street’s savviest money managers for the last two decades. He worked at Neuberger Berman, LLC, where Team Kaminsky’s assets grew from $2 billion to $13 billion during Wall Street’s lost decade.

SMARTER THAN THE STREET

INVEST AND MAKE MONEY IN ANY MARKET

By GARY KAMINSKY, Jeffrey Krames

The McGraw-Hill Companies, Inc.

Copyright ©2011 Gary Kaminsky
All rights reserved.
ISBN: 978-0-07-174922-0

Contents

ForewordIntroductionPart One WALL STREET EXPOSED1 The Lost Generation of Investors2 The Zero-Growth Decade Ahead3 Wall Street’s Greatest Myths RevealedPart Two STRATEGIES AND DISCIPLINES FOR OUT PERFORMANCE4 Take the Other Side of the Trade5 Let Change Be Your Compass, Part 1: GE6 Let Change Be Your Compass, Part 2: Disney7 What Has the Company Done for Me Lately?8 Picking Stocks for All Markets9 Do Your Own Due Diligence10 How Many Stocks Should I Own?11 Develop a Strong Sell Discipline and Manage the DownsideSource NotesAcknowledgmentsIndex

Excerpt

CHAPTER 1

THE LOST GENERATION OF INVESTORS

The two major market meltdowns of the last decade have created a new phenomenonthat I call the “lost generation of investors.” When I use the phrase lostgeneration, I mean the people who left the market between 2000 and 2009 andwill not be coming back anytime soon as a result of their experiences duringthat very difficult period. I will use the phrase lost decade the waythe Wall Street Journal does, to signify the period from 2000 to 2009,in which markets went nowhere. During the lost decade, millions of investorsleft the stock market and have never come back. Both of these phenomena occurredchiefly as a result of the two market disasters of the first decade of the2000s, which some have called the “zeroes.”

The first market debacle—the bursting of the dot-com bubble—startedin 2000 and caused the Nasdaq to crumble from a high of over 5,000 in the firstquarter of 2000 to a low of about 1,200 by late 2002. Since major market crashesdon’t happen very often, after this collapse, most investors thought that allwas well with the markets and drove the Dow to top 14,000 in 2007 (while theNasdaq has never come close to approaching 5,000 again).

During the lost decade, millions of investors left the stock market and havenever come back.

Let’s look at the year-by-year performance of the stock market for the decade2000–2009 (see Figure 1-1). Please note that all the stock chartsin the book use month end numbers. They may not look exactly like the charts youmay see on other Web sites, which are likely more volatile because they usedaily closing numbers. These percentages represent annual actual returnsof the S&P 500:

As we contemplate the lost generation of investors, we will widen our analysisto include larger and larger segments of time so that we can see how the overallmarkets performed over the long haul. However, before we widen our lens, let’stake a closer look at what the returns of the last decade tell us.

• First, we had a horrible start to the 2000s, with three down years in arow and each loss greater than that of the year before. That isuncharacteristic of the U.S. stock market. Since 1973, for example, only one outof every four years has been a down year. Of course, if we look at the entiredecade, we actually had more up years than down ones, by a margin of six tofour. But it is, of course, the magnitude of the gains and losses that counts.

• The horrific 37 percent loss of 2008 virtually wiped out the combinedgains of the previous four years. That was the year of the subprime mortgagemess, and it blindsided investors. The stock market had already had its worstdays in 2000–2002, most investors thought, so surely it was not going tocrash again. Yet the subprime mortgage mess caused a liquidity crisis that hadmany experts talking depression. The events of the 1930s were at our doorstepsagain, many people believed, thanks to the huge housing bubble that burst in2008. That bubble and the ensuing liquidity crisis drove the Dow JonesIndustrial Average from its high of 14,164 in 2007 to 6,547 in March of 2009.

• A $10,000 investment in the S&P 500 at the beginning of the decade wouldhave left you with just over $9,000 at the end of the decade. That makes theU.S. stock market the worst performing of all asset classes for the decade,worse than cash, bonds, the money market, or real estate. This negative returnunnerved many investors, leaving psychological scars that we will explore indepth later in this chapter.

We also know that investors bailed out of the stock market in a big way in 2009.In fact, we now know that more than $53 billion was taken out of the stockmarket in 2009 by jittery investors who could not wait to get out, and 2010started off the same way. In early March, $4.6 billion had been taken out ofU.S. stock mutual funds in the first quarter of 2010, according to theInvestment Company Institute (and that figure did not include ETFs, or exchange-traded funds). And if all of that is not enough to convince you of how unpopularthe stock market has become, consider this: In the first nine weeks or so of2010, world equity funds had absorbed a little less than $14 billion, while bondfunds were more than four times as popular, taking in more than $56 billion.This is proof positive that investors are willing to settle for the anemicreturns on bond funds rather than risk their hard-earned capital in the equityand mutual fund markets. This trend of leaving the market was sparked by whathappened in the last three months of 2008. During that period, the Fed reportedthat U.S. households lost 9 percent of their wealth, the most ever recorded fora three-month period.

A Brief Glimpse of Historical Stock Market Returns

To understand the lost generation in context, we need to understand how theequity markets have performed over time and what most investors expect fromtheir investment in the U.S. stock market. That is, what are the assumptionsheld by most “retail” investors (the 100 million individual U.S. investors withsome stock market exposure), and where do these assumptions come from?

We know that there have been several watershed books that have had a majorinfluence on the psyches of millions of investors. One such book, which many nowconsider a classic, is Jeremy Siegel’s Stocks for the Long Run. Firstpublished in 1994, it contains a plethora of information on the U.S. stockmarket dating all the way back to 1802, when it first began trading.

Siegel explains that a single dollar invested in the U.S. stock market in 1802would have been worth $12.7 million by the end of 2006 (assuming that onereinvested all interest, dividends, and capital gains). That’s a remarkablenumber to ponder. Siegel tells us that the U.S. stock market has averaged a 7percent gain each year over those more than 200 years, and 10 percent whenadjusted for inflation. Siegel’s book has sold hundreds of thousands of copiesover the years, and it has become a favorite tool of the great Wall Streetmarketing machine (in early editions, tens of thousands of copies of the bookwere purchased by brokerage houses). It is the poster child for buy-and-holdinvesting, a phenomenon that was held as gospel prior to the lost generationphenomenon described in this chapter (there will be more on buy-and-holdinvesting in Chapter 3).

Bear Markets of the Last Half-Century

There has been some great research done on the bear markets of the last 50 yearsor so. Examining the percentage and length of the declines tells us quite a bitabout the financial markets. Since 1957, there have been 10 bear markets in theUnited States. A bear market is defined as a loss of 20 percent or more of theS&P 500. Table 1-1 gives a list of all 10, along with the years in whichthey began and ended.

Now let’s turn the tables and take a look at the bull markets of the last half-century(see Table 1-2).

It is worth mentioning that there are several ways to slice up or synthesize thesame information. For example, if you look at these bear and bull market tables,you will note that in some years, such as 1966, 1974, and 2002, we had both bearand bull markets either beginning or ending in the same calendar year. Thisreality reveals the complexity of attempting to time markets. Employing thedefinition of a 20 percent move as an indicator of a bull or bear market, we seebull markets that exist within larger bear markets and bear markets that existwithin larger bull markets. The most noteworthy and greatest bull market inhistory occurred between 1982 and 2000. Yet within these incredible 18 years,which delivered a stunning return, there were several instances of both bull andbear markets (again, when using the 20 percent rule).

Back to the Lost Decade

These numbers tell me a great deal about the financial markets and how investorsare likely to behave in the future. When one looks at all the numbers, the lostdecade in particular is a fascinating period that reveals a great deal about themysteries of the market. Within this 10-year period, we actually had more bullmarkets than bear markets, by a factor of 4 to 2. However, it is the timing andmagnitude of the gains and losses that tell the real tale.

For example, after an incredible 18-year run-up, we lost almost half of thevalue of the S&P 500 in the period 2000–2002. Clearly, the dot-com bubblespread like cancer to the entire market. Then, later in the decade, from 2002through 2007, the S&P 500 had a stunning 94 percent gain, which helped themarket top the 14,000 level in the Dow. (The S&P 500 and the Dow generally movein the same direction. The S&P is a much better indicator, since it includes 500stocks while the Dow has only 30, but any significant move in the S&P willalways have a similar effect on the Dow Jones average as well.) However, it wasthe devastating loss of 38 percent in 2008 that destroyed any hopes of apositive decade. Despite the strong 28 percent gain in the final year of thedecade, 2009, the S&P 500 still closed well under the level at which it openedin 1999 and 2000.

Research also shows that pension fund and other high-end money managers, whocontrol large pools of funds, often amounting to billions of dollars, have alsochanged their investing habits. These managers have recently turned toward moreinvestments in hedge funds and higher-fee investments, and, most important, havealso significantly shifted their allocation from stocks to bonds.

The individual investors who were most affected by the last decade are thoseover 50 years of age. Even after the dot-com bubble, they felt that they stillhad enough time to get their money back. They did not anticipate thecredit/liquidity crisis of 2008, and they watched with terror as they lost halfof their investment portfolios on average (those with most of their moneyallocated to the stock market).

That explains the changes we have seen in investing behavior among retailinvestors as well. According to the Federal Reserve Board, household investmentsin bonds reached a record level in 2009, approaching nearly 25 percent of allpersonal holdings.

New research also proves that investors are leaving the market in recordnumbers. In 2008, the amounts of money being taken out of the stock and fundmarkets offset all of the inflows into those same markets during the previousfour years.

This psychological scarring will play a major role in defining the decade ahead.The psychological shift will have ramifications that will dramatically affectthe next generation of investors. As a result of the poor performance and returnof equities in this last decade, those who had planned to retire couldn’t do so.We know this from numbers that were released in 2010.

One statistic shows that the retirement age has shot up (from 65 to 70.5)because of what has happened to people’s retirement savings in the last 26-monthrecession. In 2010, the average value of the average 401(k) was less than it hadbeen in 2005. The researcher who came up with these numbers, Craig Copeland ofthe Employee Benefit Research Institute (EBRI), speculated that the retirementage could even increase to 75. No wonder pessimism is on the rise. According tothe EBRI, just under 90 percent of the people it surveyed say that they willretire later. The EBRI also reported that the percentage of people withvirtually no retirement savings grew for the third straight year. In 2010, itwas reported that 43 percent of people have less than $10,000 in savings and,incredibly, 27 percent of workers now say that they have less than $1,000, upfrom 20 percent in 2009.

In addition, those families that had planned to send their children to first-rate universities or simply build up their education funds could not do so.That’s why, when I look at the next 10 years, I see the same roller-coaster rideas the last 10. Stocks will go up, and stocks will go down. There will beperiods of exuberance (and note that I am not echoing former Fed ChairmanGreenspan’s phrase, “irrational exuberance”), and similarly periods in which itlooks as if the world is coming to an end.

Another by-product of the lost decade will be how specific acts of the Fed, theTreasury, and the U.S. government will be interpreted. For example, there willbe periods much like those that followed the lows in 2009, when people wereexcited because the government had stepped in to make things better with theTARP and stimulus packages. Equity markets will react positively to these typesof changes because they will view these actions as sparking productivity andincreasing GDP growth. And this will be true not only in the United States, buton a global basis.

For example, in May of 2010, when the country of Greece faced insolvency, theEuropean Union stepped in with a near-trillion-dollar rescue plan. There wassuch fear surrounding the Greece problem that the Dow soared more than 400points after that deal was announced.

In other times, those same kinds of moves will be interpreted as harbingers ofdisaster. The reasoning during those periods will be that if the government hadto take such drastic actions, then the financial outlook must really be bleak.

Investors need to inoculate themselves against the noise of the market and learnto stick to a specific buy and sell discipline. I will argue throughout the bookthat investors need to be just that, investors, and not traders (and God forbidday traders) that are reacting to every hiccup in the market.

Research That Proves the Tale of the Tape

One of the key assumptions of this book is that the next 10 years will resemblethe last 10. And I am not alone in this belief. One noteworthy author andresearcher, Vitaliy Katsenelson, has done some terrific research that backs upmy thesis. He shows that despite the unprecedented events of these last 10years, history favors a market that is likely to end the next decade(2010–2019) pretty much where we started this one.

Katsenelson explains that ever since the U.S. stock market started trading twocenturies ago, every lengthy bull market has been immediately followed by a”range-bound market that lasted about 15 years.” A range-bound market is onethat trades between two levels, usually characterized by a relatively narrowdifference. For example, in 2011, if the Dow traded between 10,000 and 11,000one would consider that a range-bound market. He also explains that the onlyexception was the Great Depression. Katsenelson also notes that the bull marketof 1982–2000 was a “super-sized” bull market. To give you an idea of themagnitude of that market, consider this: if by some miracle (and it would takeone) the Dow repeated its great percentage increase of 1982–2000 over thenext 18 years, it would hit an incredible 175,000 points by 2028.

Lastly, Katsenelson urges investors to understand the difference between arange-bound market and a bear market, and the importance of investingdifferently in each of those types of markets.

Many people believe that the great recession of 2008 to 2009, brought on by thehousing bubble and subprime mortgage meltdown, was so severe that it makes thecurrent situation analogous to the Great Depression. Let’s take a quick look atthese historical returns to gain further insight into the markets and see ifthis comparison holds any water.

In a 10-week period in 1929, from September 3 to November 13, Wall Streetexperienced the Great Crash and the market lost just under 48 percent of itsvalue. After that, from November 14 to April 17, 1930, the market snapped backimpressively with a 48 percent gain. Today, some members of the great WallStreet marketing machine are out there telling people to get back in the marketwith both feet so that they can enjoy the fruits of a similar bounceback andperhaps a new bull market. As is commonly declared in the world of finance,however, past performance is not indicative of future returns. The situations in1929 and 2009 are totally different, for reasons that I have already explained,and will explain more fully throughout the book. As a result, I foresee no suchsnapback or new bull market occurring anytime soon. The bottom line is that thedemand for stocks was far greater in 1930 than it is today.

This has a lot to do with the timing of the great bull market of1982–2000. Referring back to Katsenelson’s research, every impressive bullmarket has been followed by a 15-year range-bound market. Perhaps 2000 to 2010was the beginning of that 15-year range-bound market, which would mean that wewill continue to be range-bound through 2015. Alternatively, the last 10 yearscould have simply been a return to normal valuations following the excesses ofthe 1982–2000 market. If that is the case, we may be in a range-boundmarket from 2010 to 2025. One can make a compelling argument for eitherscenario. One can also argue that we are going to see equities significantlyunderperform other asset classes, such as real estate or bonds. The scenariothat seems most unlikely is that we’re going to have a significant expansion ofprice/earnings (P/E) ratios or an increase in the multiples paid for stocks,which is the major reason that stocks increase in value over time. (Themultiple, which is derived by dividing a company’s market price by the company’searnings per share, is also known as a stock’s P/E ratio, or simply P/E.Algebraically, earnings times the multiple will give you the share price.)

There is mounting evidence that this predicted period of underperformance couldeasily become a reality. This book will be filled with statistics that show thatin certain periods, equity prices have stagnated for long periods of time. Letme give an apt example of a single company that will bring these concepts tolife (no pun intended). Let’s look at Jack Welch’s GE in the 1990s. As CEO ofGE, Welch made GE’s stock a darling of Wall Street because he was able toachieve both an increase in earnings and an increase in the company’s multiple.Year in and year out, GE’s earnings increased, which helped GE’s stock to rise.At the same time, because Welch was seen as a superstar CEO, investors valuedthe company more highly because of his management. At its zenith in 2000, GE’sstock was trading at nearly 50 times earnings (a multiple of 50). In 2010, inmarked contrast, the company trades at about a quarter of its once-mightymultiple, selling at only about 15 times earnings (a multiple of 15).

Is There a Right P/E Level?

Let’s go back a decade to look at P/E ratios before the tech bubble burst. Atthe market’s zenith in 2000, the average P/E ratio of the S&P 500 was 40, makingstocks very expensive. If that number does not faze you, consider this: At thesame time, the average Nasdaq stock was three times as expensive as the averageS&P stock, with an average P/E of an astronomical 120, excluding stocks with noearnings! Compare that to the historical average P/E for an S&P stock, which isa far more reasonable median level of 15.7. At this time, tech stocks made upmore than a third of the S&P 500, the highest percentage of any group inhistory.

(Continues…)
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