The Greatest Lie About The Stock Market

Summary

• Stock markets don't always rise.
• Markets don't rise magically, divorced from valuation or the economies that house them.
• Failed societies have failed markets.
• Structural failure leads to performance failure for equities.

"...people will believe a big lie sooner than a little one; and if you repeat it frequently enough people will sooner or later believe it."

- OSS report on Hitler

Today, we're going to debunk the biggest, most insidious lie of all. We are constantly told The Great Lie, that over a multi-decade time frame, the stock market always rises. This is simply not true. Japan, which for years was the world's second largest economy, totally disproves this lie.

The Nikkei 225 index is far lower today than it was a quarter century ago. Anyone holding a broad-based index of Japanese stocks since 1989 has seen the value of their holdings decimated.

The Nikkei 225 index peaked at 38,957 intra-day in 1989. Yesterday, it closed at 18,886, making a 51% decline over more than a quarter century, which inversely mirrored its phoenix-like rise from the ashes of WWII.

What lessons can we draw from this?

1. Stock markets don't always rise.

2. Markets don't rise magically, divorced from the economy or valuation.

3. Failed societies have failed markets.

4. Structural failure leads to performance failure for equities.

We have already faced the always-rising stock market lie and vanquished it with facts.

The problems of a severely over-valued Japanese equity market in 1989, low birth rates, the refusal of Japan to allow for mass immigration, the aging population, the decadence of large banks refusing to write-off bad loans, and the low interest rate policy of the Bank of Japan have been widely discussed, dissected, and analyzed.

Re-hashing those severe problems is not my purpose here, except to note in passing that we also face an aging population, decadent financial institutions, and an indulgent central bank.

What is the solution for investors who must make decisions at the portfolio level and react to a murky global geopolitical outlook?

Yale Professor Robert Schiller reminds us in Irrational Exuberance that, ''[The United States] was the most economically successful century for the most economically successful nation of all time. It will not necessarily repeat itself.''

Ironically, until the end of the early 1990s, Japan was viewed as the most economically successful nation of the 20th century. Dozens of books were written about the Japanese economic miracle. Executives quoted The Book Of Five Rings in a bid to one-up each other, and constantly exhorted subordinates that "business is war."

Indeed, there is nothing magical about stock market returns in any country - even countries with gloriously optimistic macroeconomic outlooks. Any country could experience a repeat of Japan's multi-decade Nikkei 225 drop since 1989.

Therefore, I would argue for two completely different solutions depending on an investor's temperament.

Solution 1: the ownership of oligopoly businesses with few serious competitors. The robber barons understood the long-term competitive advantage of owning oligopoly businesses. You should too. An interesting characteristic that some of the businesses below share is that they are global toll bridge-like businesses. MasterCard (MA) and Visa (V) fit the bill in electronic payments; Moody's (MCO) and McGraw-Hill Companies (MHFI) have a duopoly in credit rating; Alphabet (GOOG) (GOOGL) dominates search, and the Intercontinental Exchange (ICE), CME (CME), and CBOE (CBOE) dominate global futures exchanges. These are just examples.

The notion is that the ownership of global toll-bridges which have pricing power, massive margins, and the strong prospect of growth are the best protection from single-country malaise.

This strategy has the strength of clarity and coherence, but by definition, it is not very diversified. Most global toll-bridge like businesses happen to be based in American, and second, by definition, there aren't very many global toll bridges, so the strategy is not very diversified at all. Investors should consider these trade-offs.

Solution 2: extreme global diversification on steroids. For the investor who favors a simple extreme diversification approach, there is evidence that this approach can protect against the worst ravages of failed individual countries. Credit for this graph goes to Bogleheads.org, the internet's home for the high priests of extreme diversification.

This graph conclusively proves that a 60/40 Japanese stock/bond split would not have saved investors. It's only a sizeable allocation to foreign stocks and bonds that would have helped.

Long before the Bogleheads, Sir John Templeton preached that:

"The other boys at Yale came from wealthy families, and none of them were investing outside the United States, and I thought, 'That is very egotistical. Why be so short-sighted or near-sighted as to focus only on America? Shouldn't you be more open-minded?'"

and

"In my 45-year career as an investment counselor, humility did show me the need for worldwide diversification to reduce risk."

Sir John was right. Globally, stocks may rise over a multi-decade time frame, but that is not a guarantee that a particular country's stocks will rise. In order to survive a worst-case single-country scenario, why not diversify in an extreme manner, globally, if an investor is so inclined already?

If an investor wishes to focus on company's with conservative balance sheets, reasonable valuations, and growing dividends while diversifying globally, all the better.

The two solutions that I have proposed are not perfect. I welcome readers to propose their own. I hope I have stimulated some discussion and debate.

Thanks for reading. We feature impressive, widely diversified strategy indices in our subscription service. If this post was useful to you, consider giving it a try.

Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown; in fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk of actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points, which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program, which cannot be fully accounted for in the preparation of hypothetical performance results and all which can adversely affect trading results.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.