Friday, August 31, 2007

The P07 Indices of Investment and Prosperity

kw: opinion, finance, population, investing

One investment guru I listen to is Peter Lynch. In One Up on Wall Street, published in 1989, he wrote (I paraphrase) that in the thirteen decades since the financial markets were founded, stocks outperformed bonds in every decade except 1921-1930. Therefore, he reasoned, don't "diversify" by buying both stocks and bonds; a long-term investor ought to diversify into different kinds of stocks.

As it happens, it is a little hard to find out just what "different kinds" of stocks there are. Of a dozen or so indexes out there, the only one that significantly differs from the others, long-term, is the EAFE index of "world non-US" stocks. I have found it better to diversify by looking for mutual funds having differing stated strategies, as found in their prospectuses ("prospectus" is Latin, but irregular, or I'd pluralize it "prospecti").

However, as an aside for the purposes of this post, I've had a long, hard look at the Dow Jones Industrials index (Symbol ^DJI in Yahoo Finance). This chart, from Wikipedia, shows the index from 1901 onwards, on a logarithmic scale (so you can see the first 60 years above the axis).

(Click on any image to see a larger version)The biggest visible feature is the 1929 crash, which actually took four years to play out. The single biggest drawback to this image is that each datum is in current dollars. Thus the following image is the DJI divided by the Consumer Price Index (CPI). The downloadable data I was able to get dates from October 1928, when the DJI was finally settled on thirty stocks.

After 1934, we see five generation-long trends:
  • 1934-1950 – A "flat" market, with lazy swings in a 2:1 range. This is what pink noise looks like. These are the Roosevelt-Truman post-Depression years.
  • 1950-1966 – A rising trend with more structure. The intervention in Viet Nam began early in this period, but was unknown to most. The Eisenhower highway system and other infrastructure creation set the stage for "the good life" that ended during the Johnson adminstration.
  • 1966-1982 – Dividing by the CPI shows that these "flat" years were actually a slow market fall of magnitude equal to the 1929 crash. Johnson, Nixon, and Carter each failed in his own way to reverse the slide. America was now alert to Viet Nam, and prosperous enough to focus more on the war than on the economy. The somewhat structured look continued; it was during 1950-1980 that the concept of a "business cycle" was developed. Such cycles vanished after 1984 (just when you think you've figured it out...).
  • 1982-1999 – A strong rising trend, interrupted briefly in late 1987, with the sharpest (i.e. quickest) downturn ever. Reagan prosperity, which the policies of Bush "41" and Clinton could not reverse. Note the "cycles" are absent. This is now white noise.
  • 1999 and later – A 3-year downturn and a 5-year recovery. Is this a return to 1932, or even 1966? No way to know. The Baby Boom generation is getting ready to retire, so their (our) narcissism will drive everything.
What do we make of it? I call this the P07 Investment Index, because it shows when it has been favorable and unfavorable to invest in stocks. Had you owned a lot of stock in 1966, by 1982 your portfolio's dollar value would have been just about the same, and you might have reaped dividends, but its real value became a third of what it had been.

Now, if somebody could have foreseen the strong upticks in 1967, 1970-1, and 1975-6, they could have made enough to stay closer to par, or perhaps show a minor profit. Back to Peter Lynch. He managed the Magellan Fund from 1977 to 1990. He had enough success prior to 1982 to stay on board, and after that, only an idiot could have lost money managing a mutual fund...and many idiots did! This era spawned the rise of index funds. Today an index fund is considered more of a hedge than as a way to make buckets of bucks.

There are two other factors to consider about the DJI. The increasing popularity of mutual funds after 1980 greatly increased the amount of money invested in the markets. There was also a great increase in population, which required more "stuff", and that drives an economy all by itself. I can't easily quantify the popularity factor, but I can get population figures. The following chart shows the US population and the DJI/CPI together.

Without further comment, let us divide these two. The following chart shows DJI/(CPI*Pop), scaled by taking the population in millions into my Investment Index. The result I call my Prosperity Index.

Why do I call it a Prosperity Index? It is a rough measure of the total value of the 30 DJI companies per capita, normalized to inflation. It is quite revealing. We've had three major "good times" periods since 1900: the 19-teens-20s, the 1950-60s, and the early 21st Century, since about 1985.

What does this mean for an investor? There are two relevant factors. From 1950-1966, the Depression-era, now prosperous, parents of the Baby Boom generation spent gobs of money raising their kids and sending them to college. Huge numbers of new schools, colleges and universities were built during this time. Then the combination of Viet Nam's second phase (overspending and increased inflation) and the bad feelings (especially anti-establishment) of that era made everyone over-cautious, and actually reduced, for the first time in history, most people's economic focus. Money wasn't the only bottom line for a generation, and it showed.

After 1982, many Boomers had become the establishment, and began spending gobs of money, not only on their kids, but on their "lifestyles." I don't recall ever hearing the term "lifestyle" when I was young.

Now, although the "Bush years" have been America's most prosperous period in history, there is an increasing "feel bad" atmosphere and huge numbers equate the Iraq war with the Viet Nam war, though the analogy is atrocious.

My father had the bad luck to spend his 40s and 50s trying to invest profitably, in a time when it wasn't possible. Had he known what would happen from 1966-1982, he'd have bought land. I had the good luck to invest profitably when it was easy to do so. I think I need to reconsider my strategy. 2007 looks too much like 1966 for my comfort. Stay tuned.

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