The Permanently High Plateau

May 20, 2014

One of the most famous quotes from investing lore comes from the once-esteemed (deservedly) economist, Irving Fisher. In October 1929, Fisher said stocks had reached a “permanently high plateau.” We all know about the great crash that took place a few days later and ultimately pulled the Dow down about 90%.

Fisher's comment may have been a result of wishful thinking, or just being mesmerized by his own wealth multiplication during the good times of the 1920's, when he parlayed his wife’s fortune and his own success as an inventor into the equivalent of more than $100 million in today’s dollars. 

Irving Fisher was likely among our richest famous economists. When you have that sort of money in stocks – supposedly on margin, as was the fashion of the day – you certainly aren’t going to forecast a crash. 

His fateful prediction may also have been, in the long run, accurate: stocks are the best asset class, and deserve to be more expensive. Unfortunately, experts and investors often notice the long-term opportunity in equities right before their short-term performance turns sour. Just because stocks should be more expensive, doesn’t mean they'll stay at an elevated level. 

This is reminiscent of a scene from the Clint Eastwood western, The Unforgiven. In the film, Little Bill, the town sheriff, tells William Munny, the Eastwood character, “I don't deserve this," just as Munny's about to shoot him. Munny replies, “Deserve's got nothin' to do with it.” Likewise, stocks may deserve  to remain high and perform well, but that doesn't mean they won't drop.

While it's true that stocks are the best-performing investment in the long run, they're also one of the most volatile, which can trigger poor returns far worse than the other lesser  asset classes, despite the fact that they often have stability going for them. 

We were recently reminded how lousy longer-term returns in residential real estate can be – right around the rate of inflation, yet many average investors do just fine in homes (until they start trading them like stocks during boom and bust times). Great long-term returns with periodic major slides (as stocks have) can lead to poor long-term returns as investors get sucked into the good times at inopportune moments.

In some ways, stocks have been heading toward a permanently high plateau many times during the past century, most recently the late 1990s, the mid 2000s, and now. Mathematically – and that’s one of Fisher's problems; he had too much experience in mathematics – stocks should be at least as highly valued as they are now when you compare them to the likely returns of bonds, cash, and real estate, not to mention near-dead "investments" like commodities and collectibles (of the two C's, choose collectibles over commodities so you can at least enjoy the collecting part). 

Basing decisions solely on mathematics can be as dangerous as relying too heavily on philosophy or religion. Perhaps this fatal mistake is one reason Irving Fisher made far more embarrassing quotes regarding Eugenics than any mere stock market prognostication.

The problem with the permanently high plateau theory of stocks, be it from Irving Fisher, the Dow 36,000 guys Glassman and Hassett, or Stocks for the Long Run economist Jeremy Siegel, is this : while mathematically, stocks remain your best bet to tap into America's growth, don't forget that non-mathematical factors can also trigger major interruptions in stocks. Those stocks might not permanently maintain higher price-to-earnings ratios and deliver our God-given right to five-percent-on-top-of-inflation annual returns for eternity.

Real people’s non-mathematical behavior leads to irrational booms and busts. The eventual panics can drag on the economic growth we deserve. The ensuing financial conservatism keeps capital from productive purposes. It  limits hiring and slows the economy, the effects of which we’re still experiencing in many areas. As the last crash becomes a somewhat distant memory, we move back in, guns-a-blazing. 

We’re seeing this enthusiasm now in startup companies and growth stocks. The dot com crash was two crashes ago, and the last one was more brick and mortar and touchy-feely investments – real estate, banks, and commodities. Companies based largely in the cloud are the hot stocks today.

Contrary to investing patterns at previous permanently high plateaus before 1990, ensuing economic growth isn’t keeping pace with the past. This may be a permanently lower economic growth rate, and therefore, a permanently lower stock growth rate. That means stocks may only deliver 2% over inflation, not 5% from these levels. Considering inflation seems destined for sub-2% levels, that's not much of a return. 

If this new permanently high plateau for stocks sticks – and it might, if interest rates also stay permanently low, which has been and remains one of my predictions – stock returns will be better than bonds or real estate, but stuck in the middle of single-digit territory. 

If we get another crack in the calm, a non-mathematical slide, we’ll see higher returns from the lower levels.

Bottom line? You’ll do better investing aggressively during temporary low plateaus. You still need to invest at least conservatively with some stocks at semi-permanently high plateaus like today, so long as the alternatives are not likely to do better even over as little as 5 years. 

That's a key difference between today and 1999 or 2007 – bonds and cash were a better alternative to pricey stocks back then. Today, the best alternative to stocks (and it has limited upside now) remains longer-term investment-grade bonds. Today, funds like Vanguard Long-Term Corporate Bond ETF (VCLT) yield just shy of 5%, which is not much lower than what the next 10 years of stocks will likely return annualized, with much less downside risk.

The late, great Rodney Dangerfield was known for his catchphrase, “I don’t get no respect!” When the stock market gets too much respect, be careful.