In the third chapter of "The Intelligent Investor," Benjamin Graham wants to get investors thinking about the big picture, with a macro view of the stock market over the previous 100 years. Fortunately, useful records did go back to 1871, so he was able to gain that perspective when he wrote his final revision in 1973.
He begins by noting that each investor’s portfolio will “represent a cross-section” of the immense institution called the stock market. An individual portfolio is a small ship on a big ocean, so investors should get to know something about that ocean as well as their ship.
Specifically, he is interested in major fluctuations in the price levels of the market, as well as the varying relationships among prices, earnings and dividends. Graham says of the individual investor, “With this background he may be in a position to form some worthwhile judgment of the attractiveness or dangers of the level of the market as it presents itself at different times.” A useful thing for investors wondering about the future in 2018.
He says he wants to show investors how stock prices have advanced in the past and, to make the exercise more palatable, he considers the data in 10-year averages and in three broad periods. Concerning the latter, he summarizes the data into three “quite distinct patterns,” each covering about a third of the history between 1900 and 1970:
- 1900 – 1924: a series of generally similar, three- to five-year cycles, with an average annual advance of about 3%.
- 1924 – 1949: starts with the New Era bull market, which collapsed in 1929 and was followed with what Graham calls “quite irregular fluctuations" until 1949. The average annual advance was about 1.5%.
- 1950 – 1970: The greatest bull market in history (up until 1970), as Graham calls it. There were a couple of notable corrections, but the markets recovered quickly from them and experienced an average annual advance of 9%.
The results from the third period, with its strong returns, prompted Graham to write, somewhat sardonically:
“It created a natural satisfaction on Wall Street with such fine achievements, and a quite illogical and dangerous conviction that equally marvelous results could be expected for common stocks in the future.”
Graham uses this chart to show the state of the S&P between 1900 and 1970:
Turning again to the full 100 years between 1871 and 1970, he notes that only two of nine decades saw a decrease in earnings and average prices, and no decade after 1900 shows a decrease in average dividends.
From the perspective of 2018, we know the first decade of this century began with the collapse of the dot-com boom, followed by strong advances until 2008, when another boom collapsed. If we start the second decade of this century in 2009, there is a recovery from the 2008 financial crisis followed by a now nine-year-old boom. And perhaps that helps explain why some of us walk on tiptoes, awaiting an end to this current boom.
Arguably, Graham might think the same way were he managing money in 2018. After reviewing the ups, downs and expectations of various cycles, he says:
“In the end each one must make his own decision and accept responsibility therefor. We suggest, however, that if the investor is in doubt as to which course to pursue he should choose the path of caution.”
Looking back to the 1965 edition of “The Intelligent Investor” and the very bullish highs of November 1964, he offered three principles, in what he calls the “order of urgency”:
- Do not borrow to buy or hold securities.
- Do not increase the common stock proportion of your portfolio.
- Reduce your common stock exposure to a maximum of 50% of your portfolio. Proceeds from selling stocks should be invested in first-quality bonds or in a savings account.
As he reports in the 1973 version, it turned out “our caution was vindicated.” After another short burst of gains, the Dow Jones Industrial Average dropped from 995 to 632. He sums up by saying:
“All of these judgments could be defended even today by adroit arguments. But it is doubtful if they have been as useful as our more pedestrian counsels—in favor of a consistent and controlled common stock policy on the one hand, and discouraging endeavors to “beat the market” or to “pick the winners” on the other.”
In his commentary on chapter three, Jason Zweig notes Graham had shown “how prophetic he can be,” because later in 1973, U.S. stocks were hit by a “catastrophic” bear market that lasted into 1974.
Personally, I disagree with the “prophetic” idea, while agreeing Graham had been right in his 1973 opinions. “Prophetic” does not describe Graham’s approach to the future; a cautious, common-sense investing policy seems more apt. Graham does not seek the counsel of the oracles, he seeks to develop a set of common-sense guidelines that serve investors in both good times and bad.
Not that Zweig doesn’t appreciate that. He points out the core of Graham’s position is that intelligent investors should never forecast the future by extrapolating the past. From his 2003 point in time, Zweig is also able to contrast Graham’s ideas with those of a string of bullish writers who dominated the conversation in the 1990s. Those bullish ideas held sway until the dot-com crash in 2000 made them look dangerously out of touch.
Zweig finalizes his commentary by asking that we “tune out the noise and think about future returns as Graham might." Three factors always determine the future of the stock market’s performance, he says:
- Real growth (increasing earnings and dividends).
- Inflationary growth (increasing prices throughout the economy).
- Speculative growth (or decline) because of the varying demand for stocks.
From my perspective, the most important message of this chapter is there is no constant tomorrow, just random walks down economic boulevards. We can never be sure of the future, and so the best we can do is follow a program of caution and common sense. It is, I believe, particularly relevant in 2018.
(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series (beginning with 'The Intelligent Investor: A Guide for Beginners), as well as other articles about Graham, go here.)
