July 28, 2006

Changing the Way Investors Think

Man is by nature a poor investor. He seeks comfort in the company of others, preferring to stay with the herd regardless of the consequences, rather than thinking independently and taking on the risk of being wrong alone.

Trends spanning years or decades go on much longer than many would imagine, simply because public opinion becomes entrenched - current conditions, despite their preposterous nature when viewed in hindsight, become accepted wisdom.

Whether it's a multi-decade bull market in stocks or a half decade long housing boom, individual investors look around and see everyone else doing the same thing and figure if they join in, they will be doing no wrong. The performance of individual investors managing their 401k accounts is a good example of this herd behavior - most plan participants underperform the broad indexes simply by chasing last year's star performers.

It happens over and over, year after year, and is a truly worrisome aspect of today's ownership society where it seems individuals seeking a comfortable retirement must also become investment experts early on in life (see "I have some bad news for everyone in the room")

While life-cycle funds help make a bad situation slightly less so, they are not the panacea that many believe them to be.

Why?

The accepted wisdom may be wrong.

One look at the recent performance of broad equity markets reveals a big goose egg when gains are measured going all the way back to 1999. Near term prospects are not so rosy - with a softening economy, many are predicting more weakness in stocks directly ahead.

Though most people don't realize it, the last half decade and the two decades prior were just part of a larger pattern that has been repeating at roughly eighteen year intervals for well over a hundred years.

The 80s and 90s saw a bull market in equities while the new century ushered in a bull market in commodities - most people do not yet recognize the end of the familiar and the beginning of what is now unfamiliar.

In the chart below, from Hot Commodities by Jim Rogers, it is clear that there was a sea-change a few years back where commodities began to outperform stocks. While most investors are holding steady with last century's stocks for the long run approach, others have already moved on.

Since they started keeping records, long periods of stocks outperforming commodities have alternated with long periods of commodities outperforming stocks, and with one look at the chart above it should be clear to the most casual observer where we are in the current cycle.

But, ordinary investors pay little attention to current conditions, let alone multi-decade trends.

Just as in the late 1960s when nearly two decades of superior equity gains had come to an end, when the nifty fifty were peaking like dot coms did in 2000, most individuals didn't notice the emerging bull market in commodities that ran for the next fifteen years.

Similarly, when lines were forming outside coin shops in the early 1980s so everyone could buy gold or silver bullion, few realized that the beginning of the greatest bull market in stocks was dead ahead.

Investors must fundamentally change the way they think in order to do well in the years ahead - the tide has already turned, yet so few realize it.

The commodity story goes like this

Playing out over a period of three decades or more, the complete cycle begins with a period such as the 1980s where over-investment creates a glut in capacity that causes commodity prices to decline and stay low for many years as all the new capacity was absorbed. This ushers in an era of low inflation, as in the 1990s, and as a result, publicly traded companies become more profitable and equities rise.

Commodity producers then stop investing in infrastructure and exploration because it just isn't worth it at depressed prices and, after many years, demand increases to the point that commodity prices begin to again rise, as they did in the late 1990s. As is the case today, due to years of underinvestment, prices continue to rise, inflation once again climbs, and both corporate earnings and stock prices come under pressure.

As a result of rising commodity prices, more money is spent on infrastructure and exploration, but since it takes years for new mines and new oil fields to start producing, prices continue to rise as they are likely to do in the years ahead. After years of increased investment, supply surpasses demand, and commodity prices once again fall, some thirty years or more after the cycle began.

Based on historical precedent, we are now roughly one third into the current cycle favoring commodities.

The role of emerging economies around the world and the fact that, compared to previous decades, American companies are oriented more toward finance than manufacturing both change the dynamics a bit, but iron-ore is still iron-ore and oil is still oil.

So far, save for a global economic meltdown, the cycle seems destined to repeat as it has done many times before.

To be successful, particularly during a time when increasing responsibility is laid on the individual, investors must change the way they think. Investors must recognize how the passage of time changes where money can be made and where the herds dawdle.

Most will fail to see the new trend until it is firmly entrenched - until nearly all others around them are also convinced of its staying power. But, by that time, all the easy money will already have been made and what will be left is the dangerous blow-off phase where great gains are as easy to come by as great losses.

The new commodities bull market is already changing the way investors think, but there are many who will resist this change until it is almost too late.