"Entrepreneurial judgment cannot be bought on the market. The entrepreneurial idea that carries on and brings profit is precisely that idea which did not occur to the majority. It is not correct foresight as such that yields profits, but foresight better than that of the rest. The prize goes only to the dissenters, who do not let themselves be misled by the errors accepted by the multitude. What makes profits emerge is the provision for future needs for which others have neglected to make adequate provision."
~ Ludwig von Mises, Human Action
For the typical investor and his adviser, Mises' insight about the origin of profit must seem out of touch with present day reality. It is commonly thought that the U.S. economy reaps the benefits of an entrepreneurial economy and its stock market is merely along for the ride, providing participants double-digit returns as far as the eye can see. Stock ownership has in recent years come to the masses, who fully expect to profit not from their own unique vision, but because "stocks always go up in the long run," or so they are told.
Was Mises wrong? Can the multitudes profit in the investment sweepstakes? Is capitalism, in fact, democratic? Are we entitled to all get rich together?
Looking at the great bull market from 19881999, the answers appear to be "yes". The S&P 500 returned 19.0% per annum with dividends reinvested. Even if the 20002002 bear market is included, stocks gained 14.2% annually for the 19882004 period.
Unfortunately, the typical investor did not achieve these returns. First, he was late to the party. In 1989, at the onset of a decade that saw the Dow Jones Industrials Average quadruple, just 31.6% of households owned stock. By 2001 stock ownership had swelled to 51.9%. Second, investors chased momentum to their detriment, in essence navigating the markets through a rear-view mirror. According to a recent study by financial research firm Dalbar, from 1984-2002 the S&P 500 returned 12.2% annually, yet the average stock investor earned a meager 2.6% per year.
How can Austrian economics in general and Mises' wisdom about entrepreneurial profit in particular improve an investor's returns? We think in several ways:
- Invest in market entrepreneurs with a margin of safety (sustainable businesses, reasonable valuations, and solid balance sheets). A rising tide makes it more difficult to identify true entrepreneurs, at the same time lowering investment returns by driving up valuations. Better to wait for the tide to ebb, exposing those "swimming without a bathing suit," as value investor Warren Buffett suggests. Avoid political entrepreneurs (e.g. Enron) who attempt to circumvent the whims of the consumer and the vagaries of the competitive marketplace by convincing government to grant them some sort of privilege or protection.
- Look for investment opportunity in foresight apart from the consensus. Stock prices already discount the collective expectations of investors. It is the unexpected that moves markets. The larger the crowd, the more emotional and irrational, and more likely to be wrong in its assessment of the future. An investor does not need a crystal ball to succeed, just a more accurate glimpse of the future than the rest.
- Avoid the economic errors of the crowd. The typical investor is unaware that 1) central bank induced credit expansions create artificial booms (bubbles) inevitably followed by painful waste-removing busts, 2) increased government spending plus tax cuts equals an irresistible temptation to inflate, 3) unrestricted trade is a blessing, and 4) economic law ultimately prevails despite government attempts to interfere in the process.
Just as a forest fire provides plenty of sunlight and nutrients for renewed growth, economic busts create an ideal environment for entrepreneurs to emerge. During the 1930s and 1940s, great growth stocks like 3M, Eastman Kodak, and IBM performed admirably, though they went largely overlooked. During the 19831989 technology stock bear market, hundreds of companies disappeared, only to be replaced by a new breed of saplings. This is when the next wave of growth companies like Compaq, Cisco Systems, Microsoft, and Dell Computer went public.
During the dot-com bubble of the late 1990s, Michael Dell commented on how the landscape for startups had changed since he took his company public a decade earlier. A true entrepreneurial company must deal with adversity and scarcity, he reasoned. The problem with Internet startups was that they were spoiled, showered with venture capital funds, and highly unlikely to build a corporate culture of thrift and long-term profitability. Prophetically, the survival rate for the Class of 1999 turned out to be miniscule compared to that of 1989.
The interplay of wealth creation (entrepreneurship) and destruction (government intervention) is constantly at work; it is the focus and mood swings of investors that change. During the late 1920s investors turned their attention to the positive — the wonders of new technology such as autos, electrification, radio, and the telephone. Meanwhile, the negative — government goosing of the money supply in the name of maintaining a stable price level — went either largely unnoticed or celebrated by mainstream economists as a powerful force to prevent any serious downturn, both for the economy and the growing crowd of stock investors. The "New Economics" of 1929 was followed over time by similar flights of fancy regarding government's ability to manage an economy: the U.S. "New Era" (late 1960s), "Japan Inc." (1989), and a global "New Economy" (2000).
In contrast, major stock market lows are often set when the failures of the state are exposed and become engrained in the public psyche. Depression (1932), world war (1941), expected return to depression (1949), inflation (late 1970s), and deficits (late 1980s) created the best buying opportunities for investors of the past 75 years.
How can an investor profit today? Asked another way, how does the future — viewed through the lens of an Austrian economist — differ from the outlook of the typical investor? The greater the disparity, the greater the potential for profit. (This may sound dangerously close to forecasting, an exercise Austrians know is impossible with any degree of precision. Investors must avoid this trap, instead assigning probabilities to various scenarios in an uncertain future — what entrepreneurs do all the time.)
From all appearances, investors today are optimistic. The most recent Investors Intelligence poll of investment advisers shows 56.3% bullish and just 17.7% bearish. Equity mutual fund managers hold just 4.7% of their portfolios in cash, down from 9.4% in 1988. Equities account for nearly 50% of the assets in pension funds and insurance company portfolios, up from 28% in 1988.
Goldman Sachs strategist Abby Cohen sums up the consensus view: "What matters most is that investors are confident of the sustainability of economic growth." Few doubt that tax cuts, increased government spending, and the most aggressive Fed easing in its history will have the intended effect. There is a palpable belief that Greenspan & Co. will pull all the right levers. Inflation is thought to be low and expected to remain so. Interest rates are seen drifting upward at a "measured pace," though not enough to make record debt levels unmanageable.
Residential real estate lending is aggressive and standards increasingly lax. A local banker told us that five years ago the mortgage payment/pre-tax income ratio on any home loan could not exceed 28%; today it is not uncommon to see ratios above 40%. In Orange County, California, a first-time home buyer recently secured a $360,000 mortgage with nothing down and a ratio of 50%. Nearly everyone is convinced "real estate always goes up" and that a worst-case scenario is a slowing in home price increases.
Are investors justified in their optimism? From an Austrian perspective, there appear to be several likely events, in order of their unfolding:
- The economic recovery will derail once the credit drug wears off. Since early 2001, thirteen rate cuts by the Fed (with plenty of help from the world's central banks and GSEs) stimulated little more than the accumulation of debt. From 2000 to 2004, total personal debt/GDP climbed from 66% to 83%. Personal debt payments/disposable personal income increased from 12.44% to 13.22% over the same period, despite interest rates (as measured by the 10-year Treasury) dropping from 6.28% to 4.44%. By interfering with the healthy unwinding of the tech/telecom/Internet bubble of 2000, the Fed helped foment the current much larger housing and consumption bubble.
- Inflation will return with a vengeance. The government's deficit is expanding and the Fed is on a mission to print money. If the stock, bond, and real estate asset balloons break, this new money will have nowhere to go but into goods and services. Foreign investors (mostly Asian central banks) have soaked up much of the new credit creation since 2000. Should they ever slow their appetite for dollars or actually begin selling dollars, gasoline would be added to the current smoldering inflation fire.
- The long march of global capitalism will continue. As billions continue to extricate themselves from the abyss of socialism, they will greatly expand the global division of labor. Countries like China and India will require more commodities, especially energy, as living standards improve. They will increasingly put global capital to productive use, making it more difficult (and more expensive) for Americans to attract capital merely for consumption.
Investors should sell real estate in the most speculative markets: southern California, Florida, New York, and Washington, DC. They should avoid stocks of mortgage lenders, mortgage insurers, banks, credit card companies, homebuilders, consumer discretionary items (autos, appliances, furniture, and restaurants), and luxury goods purveyors. There will be few safe havens. Perhaps stocks in consumer staples (food, tobacco, alcohol, and utilities), oil and gas, discount retailers, and manufactured housing will hold up relatively well. For the more daring, short selling or buying put options on the most egregious extenders of mortgage credit (such as Fannie Mae and the sub-prime California-based lenders) should provide speculative profits.
Year-over-year, money supply (M3) is +7.0%, import prices are +4.6%, gold is +8.8%, and even the statistically challenged Consumer Price Index is +3.1%. Investors should sell bonds and dollars, and buy gold, commodities, and short-term government notes in select foreign currencies.
Investors will eventually wake up to the reality that the U.S. is no longer the center of the universe. With less than 5% of the world's population and 21% of its GDP, the U.S. commands 45% of its stock market capitalization (up from roughly 30% in the late 1980s) and 69% of the world's foreign exchange reserves. Though there will surely be short-term setbacks, investors should keep an eye on Asian stocks (including those in Japan), commodities, and stocks in commodity-based countries over the long haul. They should also diversify their cash and fixed income holdings away from dollars.
Market entrepreneurs tend to be optimists, finding solutions where others see only obstacles. In fact, their optimism often gets them into trouble, falling for the false signals of an artificial boom that inevitably lead to a cluster of errors. Entrepreneurial investors must instead be skeptics and realists, not allowing their judgment to be clouded by overly rose-colored or opaque glasses.
Can the concept of entrepreneurial profit be applied to a political cause, such as the pursuit of a free society? We believe so. If "profit" is measured in added credibility or new members enlisted to the cause, opportunity is maximized by dissenting, not camp following. If the opposition is spreading lies to the gullible, exposing the truth can hardly be expected to make one popular in polite conversation, yet the exercise will pay the greatest dividends once the truth is revealed.
The greatest chance to advance the cause for freedom is where government is most powerful, accepted by the masses, arrogant, and thus vulnerable. These areas are easily identified because they are surrounded by the most outrageous lies and myths: the imperial presidency (Lincoln, Wilson, FDR, and recently Reagan to a lesser extent), the war on terror, and the seemingly omnipotent and omniscient institution of central banking.
Investing is an endeavor in which the most succulent fruit is reserved for the contrarian. As the size of the crowd and level of group-think increase, so does the opportunity for profit. For both the entrepreneurial investor and promoter of the free ideal today, this is welcome news indeed.
July 13, 2004