Chapter One: A Lifetime Planning and Investment Horizon Today
When I first published The Great Boom Ahead
in late 1992, most experts and people felt the long-term prospects for our economic future were dim at best. Bankruptcy 1995
was the bestselling book of the times. Similarly, I published The Roaring 2000s
in early 1998 just as the markets were about to take their biggest correction since 1990 and the developing world was falling into a severe recession. I predicted a correction in the Dow to the 7200 to 7600 level by August to November of 1998 on page 292. In that book I was even more bullish, projecting a Dow as high as 35,000 by 2008. The astounding market rebound since early October 1998 has again vindicated the basic fundamentals driving our economy, the massive spending and productivity trends of the largest generation in world history, the baby boom. In this book I will look at the very specific investment strategies for leveraging the greatest boom in history that will see its grand crescendo in the next decade, especially from around late 2002 into 2008 or 2009. But your life and your investments will have to thrive beyond this great boom. I will show you how you can prosper in good times and in not-so-good times or even the worst of times. It all comes down to understanding long-term trends.
Let's face it. There have been many good books on investments and financial planning. But they all tend to focus on the same issues. You need to save more and spend less. You need to have a long-term strategy and stick to a disciplined system of investing. You need to take advantage of tax-deductible and tax-deferred vehicles like your 401K. But everyone has heard this, and some of us practice this boring approach, while most investors continue to think they can beat the pros by selecting their own stocks, save commissions by trading over the Internet, and time the markets by listening to the best experts on TV. In fact, most studies show that the boring investors who stick to a systematic plan and use an objective financial advisor do much better. But what is the real secret to successful investing?The secret to successful investing is understanding very fundamental long-term trends...and buying when companies and investments in those sectors are undervalued, when no one wants them. There are always investments that are booming, even in bad times. And we will see a very difficult economy after 2009.
This is another popular topic in investment books, how you can use your own common sense to spot new trends. But can you really spot the next Wal-Mart in its early stages, as Peter Lynch did? Did you see the potential worldwide for Coca-Cola in the early 1980s, as Warren Buffet did when the market was getting saturated in the United States? Are you going to spot the next hot mutual fund or sector in the economy when it is down and unpopular? Or are you going to buy that mutual fund right when it is at the top of its cycle, with the highest ratings, and then watch it underperform and sell it before it starts singing again? Are you going to anticipate the next 10% or 20% correction in the stock market and get out right at the top and back in right at the bottom? Will you buy Japan 10 years from now, when it is booming again, after it has been a terrible investment for almost two decades? Will you buy bonds when the Dow is at something like 40,000, after bonds have yielded the lowest returns in decades?
So the real question is how do you understand long-term trends and how do you actually get on a systematic investment plan that keeps your emotions from working against you? Your emotions will always tell you to buy what is already hot or to avoid what has underperformed! How many of you trading on your own have beat the S&P 500 in the last 5 or 10 years? Forget how much fun you have investing -- or gambling, as some would put it. Forget the ego trip of beating the pros on your own computer. The Beardstown ladies seemed to do this, until they were audited! They made 9%, not the 23% claimed, while the S&P gained 18%.
Are you willing to compromise the rest of your life and underperform the markets by as much as 4% to 10% (as studies have consistently shown) in this extraordinary boom? Do you know the price of that on your net worth and life and retirement options 20 to 40 years from now? The difference between 10% compounded annually, which most people tend to get, and the average 17% growth rate of the S&P 500 since 1982 over the next 10 years alone is 96.79%. And I will show how you could earn as much as 20% to 24% over the coming decade without taking substantially more risk than an index fund. How do you beat the S&P 500? By investing in the best sectors of the S&P 500, sectors that diversify each other and reduce the risks of investing! But you can't just pick the sectors that did the best in the past; that is a proven way to underperform the markets. You must understand what sectors will do well in the future, based on fundamental trends.
And what will you do when the stock markets in the United States start going down for many years, as they did from 1929 to 1942 and from 1968 to 1982? If you have been underperforming in this great boom, how will you do in the next great bust? Won't your emotions tell you that the stock market is the best bet when it has been going up for 26 to 27 years? That is when it goes down by past history.Here's the real truth: Life should be interesting; investment and financial planning should be boring. You should focus on what you enjoy and do best in life and let an objective financial advisor put you on a proven system for building the wealth that you deserve to achieve your life goals. Or you can set up such a system yourself if you have the discipline. But you can do that only if you understand the fundamental trends driving our economy.
In the greatest boom in history, you should be able to live an enjoyable lifestyle and plan adequately for your future. I don't think that The Millionaire Next Door
necessarily represents the guide to your best strategy for the future. It was an enlightening book precisely because it showed how not to enjoy life from being successful. The typical millionaire profiled got rich by saving money and having a very boring life that entailed constant scrimping and doing everything himself or herself. The rise in our standard of living throughout history has instead come from focusing more on specialized skills and delegating more life tasks to others who specialize in what they do best. You should be able not only to retire in style but to choose even more what you really want to do in life after your kids have left the nest.
The key to achieving your dreams is to understand the most fundamental trends driving our economy. Only then can you be clear enough to plan your life and to find and trust a competent advisor to put you on a systematic investment plan that you can feel good about. A plan you can stick with even when the markets are down 20% or more for a few months, as in late 1998. The greatest mistake is selling in such corrections and not buying more instead. But you can't have the conviction to do that even with the urging of a good financial advisor or mentor unless you understand the most fundamental of trends and know that the markets are heading higher.
It's not enough to trust long-term statistics that prove that stocks and equities provide superior returns over time. What if you had bought a blue chip stock portfolio in 1929? You would have suffered up to 90% losses into 1932 and had to wait until 1953 to break even. If you'd had to retire on that portfolio in the 1930s and 1940s, you would have been in deep trouble. The same would have occurred to a slightly lesser degree after 1968. Such a blue chip portfolio would have fallen 70% (adjusted for inflation) into 1982, and you would have had to wait until 1993 to break even.
The purpose of this book is to take a very different look at economic trends that I will summarize from my earlier books, The Great Boom Ahead
and The Roaring 2000s.
You can see all of the important trends that will affect your investments for decades to come. Just because economists don't understand our economy doesn't mean that you can't. Our economy is driven by the predictable habits of people like you. Hence, you will be able to understand how to prosper in good times (the next decade) and bad times (the decade to follow). But what I will do in this book is look at the nitty-gritty details, from the predictable changes in your cost of living to the specific sectors you need to be investing in to the intricate subtleties of tax and estate planning. And perhaps most important, how to choose the right financial advisor for you, someone who represents you, not a salesperson for investment products.
But let me start by giving a new, more summary view of the very simple generation-based trends that drive all the key long-term trends in our economy and investments.The Generation Wave
The most important forecasting tool for our economy and the stock market in my past books is the spending wave shown in Chart 1-1. The peak of spending of the average family today in the United States (and in most developed countries) is age 46.5. This comes from reliable surveys of consumer spending taken every year by the U.S. Bureau of Labor. I simply lag forward the birth index, adjusted for immigration, for this peak in spending, 46.5 years later. This simple indicator will tell you when our economy and stock markets will boom and when they will bust almost five decades in advance. Refer to The Roaring 2000s
for a more detailed explanation.
The critical insight is this: The massive baby boom generation will drive spending and productivity trends higher into late 2008 to mid-2009. Therefore, this unprecedented economic and stock market boom will continue for the next decade. Then there will be an economic downturn that will change your life and your investments. You have to plan for the boom and the bust today! And obviously your kids' jobs and education prospects will be affected by this cycle.And where do I see the stock market headed? Likely to around 40,000 on the Dow by 2008.
That may sound outrageous, but it's not. That is simply the same 16% average annual rate of increase on the Dow and S&P 500 since this boom began in late 1982. Chart 1-2 shows the Dow channel of growth on a ratio graph, or a constant rate of growth, instead of a normal numerical graph. It projects a peak of around 41,000 by late 2008, even higher than my 35,000 forecast in The Roaring 2000s.
If the boom were to peak a year earlier, the top of the channel would be at 35,000. And it is likely that this top channel trend line would be exceeded briefly at the top of this bull market.
Note that the market has been transitioning from the lower end of this channel since 1994 and has yet to hit the upper end and achieve overvaluation to the same extent as in late 1987. That also occurred in the last 26-year bull market from 1942 to 1968, when valuations shifted to higher ranges from the mid-'50s into the early '60s. That is why the gains in the stock markets have been so extraordinary since 1995, averaging closer to 30% per year. By late 1999 to mid-2000 this valuation boom is likely to see its zenith, and then we will have to settle for average annual gains more in the 14% to 18% range into 2007-8. Gains of that magnitude will still double your wealth every 41/2 years! I will show in Chapter 2 how you can construct a portfolio that can be positioned for potential gains in the 20% to 24% range without taking significantly more risk than in an S&P 500 index fund. The Dow could hit the top of this channel between late summer or early fall. We could then see a sharp correction sometime between August and the end of the year that would represent a great buying opportunity.
There are two reasons I have shifted to this slightly more bullish channel since 1998. The first is the strength of the rebound from the late 1998 correction, which shifted the average growth rates even higher. But the most important reason is that this projection of 41,000 in 2008 also coincides very closely with a longer-term channel extending back to 1901 in Chart 1-3 (page 28). This channel projects a Dow of over 250,000 by 2040-plus, when the next generation's spending boom will be in strong force. But we could also see the Dow first go as low as 10,000 to 15,000 during the down phase of the generation cycle into 2020 to 2023.Generation Cycles Drive All Key Trends in Our Economy
Here's the summary insight. Every major trend in our economy -- from earning and spending to saving and borrowing to inflation and innovation to productivity and business revolutions to our cradle-to-grave spending habits in every product and service industry -- is driven by the predictable aging of new generations of consumers and workers. New generations come in waves about every 40 years, as we can see in Chart 1-4. These generation trends have been documented in great detail (before annual birth statistics were available) in two great books by William Strauss and Neil Howe: Generations (1989) and The Fourth Turning (1997). But for now, simply note the size of the baby boom generation when adjusted for the births of all legal immigrants compared to the Bob Hope generation wave before it. Everything that baby boomers do exaggerates every trend in our economy predictably. This is why you can see all the key economic trends decades in advance and plan your life and investments around them.
Let me summarize my full array of principles from The Roaring 2000s
in two simpler charts. The first one, Chart 1-5 (page 30), summarizes the cycle of key events and expenditures in the life of the average consumer, which drives our economy as new generations move through these predictable cycles in peak numbers. As kids we need predictable things, from diapers to baby food. We enter kindergarten and elementary school and then junior high and high school. But let's start here with college. We have to build new colleges and universities as more people turn age 18.
Only after people enter the workforce, typically after high school or college, do these new generations become productive workers and consumers who earn and spend more money and drive economic boom periods. They move into apartments as they get their first jobs, and demand for apartments peaks when they get married around age 25 1/2 to 26 today. They suddenly need stores and shopping malls as they get married and form households. Shopping center development peaked in 1986, 25 years after the peak of the baby boom birth cycle in 1961. They have kids in their late twenties (age 27 1/2 to 28, on average) and then buy starter homes into around age 33 and go into debt at the highest levels relative to their incomes by age 34 furnishing those homes. That's what caused the unprecedented rise in home prices into the late 1980s and the highest debt levels in history just after. The pressures of buying a house and raising kids cause most people to be very price sensitive and to favor discount stores and products (like Wal-Mart in the 1980s and early 1990s for baby boomers).
Then many trade up to better homes by age 44 and fully furnish them by age 46 1/2 to 47, just when the kids leave the nest. Now they don't need a bigger house, more furnishings, more food in the refrigerator, and more clothes, and the average family spends less after age 47. But empty-nest couples then spend more than ever on vacation homes, travel, and leisure into around age 52. Then, of course, we retire around age 65, driving up the cost of retirement homes, and spend the most on health care into our seventies and eighties. In The Great Boom Ahead
and The Roaring 2000s,
I described many more everyday things, from potato chips and food cycles to veterinary services to motorcycles and cars, and the entire cycle in real estate and housing purchases.
You can see how such predictable cycles in generation spending patterns drive our economy, from the most micro industries to the macro economy. That is the fundamental trend that drives our economy and investment trends: simply new generation waves of consumers and workers. Chart 1-4 (page 29) shows the massive size of the baby boom generation versus the Bob Hope generation, which was only magnified by a large immigration wave from 1978 into 1991. I have calculated legal immigrants into the birth index by adjusting for their age of entrance. This means I am still excluding illegal immigrants, who are substantial in numbers. The baby boom generation is roughly five times the size of the last generation birth wave! It is this massive generation that has and is exaggerating all economic trends, from school expansion in the '60s and '70s to the starter home boom and debt explosion of the '70s and '80s to the economic boom from 1982 into 2008. And now comes a savings and investment boom from the mid-'90s on. The baby boom's massive savings, along with their peak spending and productivity, will continue to elevate the stock market to unprecedented heights in the next decade.The point: As a baby boomer or other investor, your best strategy is to bet on the predictable spending and saving trends of this massive generation, which will combine to drive the stock market up until 2007 or 2008. The sectors of the economy that will benefit the most will be technology, financial services, health care, and travel and leisure, which will boom as baby boomers enter their forties and fifties. An even greater baby boom in emerging third world countries will drive an international boom that will be even greater after the emerging-countries bust in 1997 and 1998. Japan is the only major developed country that will continue to suffer from a baby bust after World War II.
Chart 1-6 summarizes the key trends that drive our economy and investments that are caused by the generation cycle. Workforce entry averages around age 19 and is moving forward as more people go to college. Up until this point, young people represent a growing expense by parents and government to raise and educate them. When they enter the workforce, corporations have to train them and provide huge investments in office and work space, not to count the investments by governments and businesses in new technologies, infrastructures, and new companies' innovations that these new generations create. This is what causes inflation. Just ask yourself this commonsense question, true or false. Are young people expensive? Highly educated young people dominate innovations technologically and socially as they graduate from college around age 22. That's what drives innovation cycles in our economy.
Note that the highest rates of inflation in our country's history peaked in 1980, exactly 19 years after the peak of baby boom births. And innovation or venture capital returns peaked in 1983, 22 years after the birth peak. As the generation cycle emerges, think of the first 19 to 22 years as high expense, high investment, and high innovation, and conversely low earnings, low productivity, and low spending. That is the first phase. The next phase brings the great economic boom periods. Rising earnings, spending, and productivity. The new technologies the generation innovated while young and the investments in infrastructures and training for them start to pay off. Here we see a booming economy for about 26 to 27 years (ages 19 to 46 1/2 to 47 1/2) with falling or low inflation rates.
Midpoint into their earning and spending years, we see a peak in debt ratios just after buying the first house and furnishing it around age 34. That is why we saw unprecedented debt ratios into the late 1980s and mid-1990s. Now debt levels are leveling off and even falling. Then we see the real economic revolutions as the new generation moves into its power years, from its forties to its sixties, peaking around age 58. That is when they control most companies and institutions, including governments. That is when they also have increasing savings and investment capital to create real change (savings accounts grow dramatically from the late thirties to around age 67 to 68). That is when you see the real work and management revolutions that fully leverage the technological and social innovations that began when the generation was young and innovative. That is when new technologies and products become mass affordable. That is when management and work revolutions occur that change how we work and live and advance our standard of living the most.Economic and Technology Revolutions Every 80 Years
There is another important dimension that I covered in my past books. Every other generation (as documented by Strauss and Howe's research) is individualistic and change oriented. Every other generation we get the radical new technologies and social trends that create a whole new economy. The generations that follow are more conformist, civic-minded, and collective oriented, like the Bob Hope generation. The Henry Ford generation brought us electric motors, telephones, cars, movies, planes, and much more when they were young and innovative, from the mid-1870s into the early 1900s. The next generation's innovations were more incremental. They extended the new industries further into mass-market affordability and saturation.
The Bob Hope generation's innovations included power steering and brakes, automatic transmissions, and superhighways for cars and, of course, the jet engine for planes. The economy peaks in saturation with the spending cycle of the conformist generation, as occurred into the late '60s and early '70s with the Bob Hope generation boom. Then the next entrepreneurial generation comes along and creates the next innovations that drive a new economy, as the baby boomers did from the late '50s into the early '80s. Their spending then drives these new technologies, industries, and products into the economy, and their power years bring in radical new approaches to work and management, such as the assembly line revolution from 1914 to 1945 and the network revolution from 1994 into 2025 that is just now emerging with the explosive growth of the Internet.
So about every 80 years or every two generations, we see an economic revolution that starts when the entrepreneurial generation is young. These revolutions get ushered into the mainstream of our economy when the entrepreneurial generation moves into its peak spending and productivity years and the beginning of its real power years. This occurred for the last entrepreneurial generation, the Henry Ford generation, in the Roaring '20s. The massive baby boom will move into this powerful spending and productivity period of work and management change in the Roaring 2000s,
the next decade, from around 2002 to 2008 or 2009. There are many predictable changes that will occur that you can profit from in your investments.
I summarize the network revolution in management that will make the re-engineering revolution look like child's play, or let's say the appetizer instead of the main course, in Part 3 of The Roaring 2000s.
Chart 1-7 shows how we are moving on an 80-year cycle from an economy that made standardized products and services increasingly mass affordable to one that will make customized products and services mass affordable. Finally, we as consumers will get the type of personalized service that companies have only been promising in the past decades. We are about to enter a new era of prosperity. Actually, it already began in the mid-1990s.
Here's a summary chart of the economic and investment cycles that are generated predictably over each 80-year economic revolution and with each 40-year generation cycle within. But first remember that we are in the midst of a more massive 500-year cycle. Every 500 years or so, the population of the world explodes, quadrupling or more in a century. These massive generation waves of new people drive even larger innovation cycles, such as those initiated by the printing press and the discovery of America and the scientific revolution to follow from the 1500s forward. Ever since the printing press, the last information revolution, we have been in a rising cycle of mass production. Now with the recent explosion in world population and the computer revolution, we are entering the beginning of an 80-year cycle of mass customization, a cycle that will continue over the next 500 years or so. This represents a greater revolution than we can imagine. We haven't seen the real information revolution yet. It is just emerging, as the printing press revolution did in the late 1400s and early 1500s, and as the car, phone, and electric motor revolution did in the Roaring '20s.
Over this two-generation cycle in which new economies emerge, there is a recurring four-stage cycle, as shown in Chart 1-8. Each stage favors certain asset categories of investments and disfavors others. Perhaps this is the most critical insight of this book.There are four distinct stages and six investment phases in the economic cycle that require very different long-term investment strategies. If you understand this cycle, you can prosper in good times and bad times.
It is great news that the current bull market will continue until around 2008. But the reality is that we will face a deflationary downturn after 2009 that will last until around 2022 to 2023. Baby boomers will be moving into their most important preretirement years of investment accumulation when most stock markets will be down! That means your retirement could be more threatened by that downturn than by your failure to save in the past or the bankruptcy of Social Security. And your career and earnings capacity may be in jeopardy after 2009 as well.
Let's review this 80-year economic cycle and summarize each stage, emphasizing the two phases ahead.Stage 1: Inflation and Innovation
The first stage starts as the young, new, individualistic generation is entering the workforce during a long-term recession period resulting from the downward spending wave of the previous, conformist generation. The last example would have been late 1968 into late 1982. The Bob Hope generation had peaked in its spending, causing a wave of recessions in 1970, 1974-75, 1980, and 1982. Inflation rose to the highest sustained levels in history. We saw the monumental microcomputer revolution emerge, from the first computer on a chip in 1971 by Intel to the first popular personal computer by Apple in 1977 to the start-up of Microsoft in 1983. Venture capital and start-up activity peaked between 1979 and 1983. In this period a new economy began to emerge, and that is always an inflationary process due to the huge investments it takes to retool for new infrastructures, new technologies, new companies, and the incorporation of a new generation into the workforce.
In the previous 80-year economic cycle, involving the emergence of cars, electrical appliances, and phones, the inflationary phase occurred from around 1898 into 1916. Since immigration created the greatest numbers of the Henry Ford generation, this cycle was abbreviated. Immigrants come into this country around age 30, on average. They spur innovation and infrastructure expansion on a shorter fuse (about a two-year lag) and are about 11 years older than the average native-born worker when they enter the workforce. Immigration surged at unprecedented rates beginning in 1898 and peaked in 1914 with the advent of World War I. Inflation rates continued to rise past the normal 1916 peak (based on a two-year lag on labor force growth) into 1920 because of the huge costs of the war effort. Then inflation fell dramatically from 1920 into 1921 because of the winding down of the war effort, creating a recession before the Roaring '20s were ushered in. We saw a peak in start-up activity of today's Fortune 500 and mass-market brand names between 1900 and 1907, a little less than 80 years from the peak in start-up activity between 1979 to 1983 in the recent cycle.The best investments in Stage 1 are:
- Real estate, especially commercial
- Small company stocks
- Select international regions for stocks
- T-bills and CDs
Real estate booms because a new generation is starting to enter the real estate cycle. This starts with new offices and industrial space (which peak with workforce entry around age 19), then apartments and multifamily rentals (which peak around age 26 with marriage), and then starter homes (which peak around age 33). Obviously, in the earlier part of this cycle, commercial real estate is the best investment. In the latter part apartments do better and starter homes begin to emerge with significant force. But real estate across the board also booms because of inflation. Real estate is a leveraged hedge (due to mortgages) against inflation for investors. So this is the best overall investment in what can seem to be very turbulent times of inflation and innovation.
Small company stocks also do very well even when the overall stock market is declining because of worsening recession and inflation. Why small company stocks? Because a new generation is innovating new technologies, products, and social trends. Small companies are more nimble at exploiting such new niche markets, while large companies are slow to change and adapt. What's more, the large companies are losing their loyal customers from the last generation, who are becoming savers, not spenders. In fact, this brings us to another critical insight:Small companies outperform large companies dramatically in off periods of recession and innovation. Large companies outperform to a smaller degree in sustained boom periods in which niche markets move mainstream.
Many financial experts tell us to diversify our portfolios between large and small company stocks. The truth is they do well at very different times, and this is a disastrous way to diversify our portfolios. Therefore, we should emphasize small company stocks in the off periods and large company stocks increasingly in the boom periods. Chart 1-9 proves this point conclusively. The innovation phase of the baby boom generation was from 1958 into 1983 on a 22-year lag to its birth cycle. Small cap stocks outperformed large caps more than 6 to 1 on a cumulative basis! This period culminated in the inflation-recession stage from 1968 to 1982. However, the best time to have bought small cap stocks was after the extreme 1974 crash, as they got hammered even more than large cap stocks in that short period. Most of the outperformance from 1958 to 1983, 4 to 1 in cumulative returns, occurred from 1974 to 1983. An important rule of thumb is to buy small company stocks as we enter a long-term down period in the economy and stock market only after a large crash in the stock market of at least 50% from the top, preferably 70% (using stock indexes adjusted for inflation). I will show in the section on the deflationary stage that small caps also outperform similarly.
The 1970s also saw the boom really get started in Japan while many third world countries benefited from rising resource prices. Selective investment internationally can reward the investor in such a cycle. Japan has a very different generation and birth cycle from those of most other developed countries and was booming in the 1970s while the United States and Europe were busting. I will show Japan's birth and economic cycles in Chapter 3. Although there was money to be made in emerging country stocks, the volatility, especially in 1974, was too much for most investors. That's why I stress "selective" when talking about international investments. Japan represented a solid developed country with strong growth and low inflation due to its counter-cyclical generation trends. That would have been another great place to invest in the 1970s.
The investments to avoid are obviously large cap stocks, but also intermediate and long-term bonds. Rising inflation causes bonds with longer-term maturities to depreciate as new bonds are issued with higher, more attractive rates as inflation rises. Very short-term debt instruments like T-bills and CDs allow investors to constantly trade up to higher short-term rates. This is where conservative investors who need income should concentrate. Gold as a hedge against inflation also does well in such a period, although that may not occur as much in future inflationary stages as gold loses its function as a monetary metal in the information age.Stage 2: The Growth Boom
As the individualistic generation enters its spending wave, the economy starts to boom again, and inflation starts to fall as the new generation and its new technologies drive increased productivity. The spending wave in Chart 1-1 (page 25) shows how the massive baby boom started our present boom in late 1982. The new generation increasingly buys the new products and technologies as their spending power grows. That causes them to emerge from niche, luxury markets increasingly into the mainstream, especially as the productivity from new technologies makes them more affordable. This creates a race for leadership to see which companies will dominate these new mass markets, from computers to specialty coffees. Hence, large company stocks increasingly outperform small company stocks, as we can see in Chart 1-10. But large company stocks don't outperform by nearly as wide a margin as small caps do in the off periods, more like 2 to 1 in cumulative returns since 1984. That gap could widen in the coming decade.
Large company stocks seemed to trounce small company stocks in the growth boom of the Roaring '20s. There are data only for the last four years, from 1926 through 1929, from Ibbotson and Associates, but in that period large cap stocks averaged 19.8%, compared to a 4.5% loss for small caps. But as the smaller echo baby boom generation enters its innovation phase from 1998 on, small caps will do better than in the past.
This growth boom period of about 26 to 27 years actually splits into two phases, the first with falling inflation, the second with relatively flat inflation. That means two different investment portfolio strategies.Phase 1: Falling Inflation Rates
Inflation falls dramatically during this phase, creating the best performance you will see from long-term bonds and fixed-income securities. From 1981 into 1998 inflation rates fell from about 14% to near zero. The average return from 30-year U.S. Treasury bonds was 13.9%. That wasn't quite as good as the S&P 500, but given that you were guaranteed to get your interest and principal, this was a great time for investors who needed fixed income and were averse to taking risk. And your bonds appreciated in value from falling inflation and interest rates when you sold them.
During this phase the real estate cycle remains strong in starter homes, the greatest expenditure phase in the real estate cycle. Therefore, residential home prices boom the most in this period, especially in the earlier phase, as they did from late 1982 into early 1990 in this boom cycle. The new generation buys more starter homes into age 33, which creates a plateau in starter home buying, as occurred from 1990 into 1994 on a 33-year lag of the peak baby boom birth rates from 1957 to 1961. Then starter home demand grows slower than the economy. Commercial real estate falls off in demand on about a 19-year lag as workforce entry peaks just before the boom starts. Phase 1 of the growth boom occurred from late 1982 into early 1998 in the baby boom cycle.The best investments in Phase 1 of the growth boom are:
Phase 2: Low, Flat Inflation Rates
- Residential real estate
- Large cap stocks
- Long-term bonds
This is the phase we have entered since 1998. As new technologies create very strong productivity and as the new generation ages into its most productive years (in the midforties), inflation settles into a low or near-zero range. This occurred in the Roaring '20s as well. This means that bonds offer very low yields and little or no appreciation potential from falling inflation rates. Bonds are the worst investment in this phase. Large cap stocks continue to outperform as the race for leadership comes to a head in the latter phases of the boom. But small cap stocks may fare a bit better after 1998, when the innovation wave of the echo baby boom kicks in. Trade-up homes and increasingly vacation home and resort real estate boom even more strongly in the real estate sectors. Lagging international regions tend to be forced to catch up to the business practices of the leading nations (like the United States in this economic revolution). Therefore, international equities do well in nations that have strong spending waves from aging new generations.
pardThe best investments for Phase 2 of the growth boom are:
Stage 3: Deflationary Shakeout
- Large company stocks
- International stocks
- Resort and high-end residential real estate
The next stage is the worst for most investors and workers but the best for the most financially savvy. It is the depression era, in which we see falling prices or deflation and very high unemployment rates. This period is not an innovative period of bringing in fresh new technologies or industries. It is a time when the economy shakes out the remaining companies that didn't win the race for leadership. This means divesting productive facilities and laying off workers. The few remaining leaders in each industry absorb the market share and the most productive facilities and workers from the failing companies. This stage of the last economic cycle came between 1930 and 1942. Stocks were generally down dramatically from late 1929 into 1932. Prices fell equally dramatically from 1930 into 1933. Stocks lost 90% of their value, and real estate prices plummeted. Stocks were still down 70% in 1942 when the next bull market started.
Of course, such deflationary times were good for long-term bonds. There was a flight to quality from equities, and falling prices resulted in falling bond yields. From late 1929 into 1942, yields on the 30-year U.S. Treasury bond fell from about 3.5% to 2%. That means bonds appreciated in value as interest rates fell. More important, principal and interest were guaranteed in abysmal times and unstable conditions. And money bought more because of falling prices of everything from food to housing. Investors had to adjust for deflation in those times. From 1930 to 1942, total returns on long-term government bonds averaged 3.5%; and on corporate bonds, 6.19%. Such returns of 3.5% to 6.1% were worth more like 6% to 9% in real purchasing power value. Not as good as the stock yields in the boom periods, but very good compared to other investments that were mostly falling. In a deflationary period, bonds generally bring the best risk/return ratios.
And it shouldn't surprise you too much at this point to learn that small company stocks did very well, but again only after the crash. Chart 1-11 shows from 1932 to 1946 that small company stocks outperformed by a margin of about 6 to 1 on cumulative returns in just a 14-year period. That is astounding!
The same logic applies as in inflationary periods. A new generation is entering the economy, innovating and buying new technologies and products. The smaller companies are more adept at attacking these new markets. However, there is a difference in the nature of innovation. These are incremental innovations that extend the growth industries that emerged in the growth stage. But it still takes smaller companies to give birth to these new innovations at first.
There is another valuable trend to understand in this very turbulent period. In The Roaring 2000s,
in Chapter 10, I show how new technology revolutions eventually cause a shift in population to new areas where the quality of life is higher and the cost of living is lower. The massive shift from the cities to the suburbs accelerated from the 1930s into the 1960s because of the mass adoption of cars, phones, and home electrification. The mass adoption of the Internet (which I also cover in Part 2 of The Roaring 2000s)
between 1994 and 2008 will also cause a massive shift to exurban areas outside the suburbs of large cities and to attractive small resort towns. Therefore, the new growth areas in real estate are great investments in depression periods but, like small cap stocks, best after the crash in stocks and real estate values.The best investments in Stage 3 are:
Stage 4: The Maturity Boom
- Long-term government and very high quality corporate bonds
- Small cap stocks (only after the crash)
- Exurban real estate and commercial real estate (especially after the crash)
When the next, or conformist, generation enters its spending cycle, we see a boom wherein the industries of the last revolution move fully into mainstream market saturation. In the last 80-year cycle, that would have been 1942 into 1968 for the Bob Hope generation. These booms favor large and small cap stocks, residential real estate, and international equities. Large cap stocks tend to do better in the first half of the boom, and small cap stocks start to outperform in the second half as the next individualistic generation starts to move into its inno-vative stage, creating the radical innovations for spawning the next economy and 80-year cycle. The next maturity boom will begin around 2023 with the millennial generation and last until about 2050. But that is too far off to concentrate on for now. Note that, as in the growth booms, there are two phases that slightly favor different investments.The best investments in Stage 4 are:
- Large cap stocks (first and second phase)
- Small cap stocks (second phase)
- Residential real estate (first phase)
- Commercial real estate (second phase)
- International stocks (second phase)
There tends to be a slight inflationary bias in this phase that does not favor long-term bonds. And again, in the second half of the boom, international stocks tend to follow the practices of leading nations like the United States and perform well.Portfolio Strategies for the Next Decade
Given that we are entering the second phase of the growth boom, you as an investor should be focusing on large cap equities, international equities, and exurban, resort, and high-end residential real estate. The next generation will also cause rising values in rental and multifamily housing. Small cap stocks greatly underperformed from 1995 into 1998 and got trounced in the correction of 1998. Therefore, they may outperform a bit into 2000 or so. But large caps should rule in the next decade of the Roaring 2000s.
In Chapter 2, I will look at how to create a portfolio of mutual funds or large cap stocks to beat the S&P 500 with minimal risks by being in the best sectors that will be leveraged by baby boomers.
In Part 2, I will take a look at the most exciting arena of this portfolio strategy for the coming decade. Note that while large cap stocks in the United States have achieved high valuations, many international markets have experienced the worst beating since the mid-1970s. There is great value in understanding which countries have the potential to outperform in the coming decade and which ones don't. Japan is a country that will clearly underperform, whereas its neighbors, like Hong Kong, South Korea, Singapore, and Taiwan, will very likely outperform in the coming decade. A look at the simple age demographics and technological trends throughout the world will make us very savvy investors in the coming decade and beyond. In Chapter 3, I will look at the demographic and technological prospects for the more-developed countries around the world, using the very simple indicators I have used for the United States.
But remember that the greatest population increases in the last century occurred in emerging countries. In Chapter 4, I will look at the prospects for growth in the massive populations of the emerging third world nations. The massive growth trends around the world in the coming decade will only serve to further leverage the larger companies that can expand efficiently overseas with proven brand names here. This is another reason to be invested in the largest company leaders in old and new industries over the coming decade, as opposed to small company stocks, except in exciting new areas like biotech and e-commerce.
In Part 3, I will look at the lifestyle dimensions of planning your life, from where you can live to what the cost of living will likely be well into the future. And finally, in Part 4, I will look at how to find a competent financial advisor who will represent you and how to leverage your wealth with simple tax strategies.
Let's first look at how to create the ultimate portfolio for the Roaring 2000s!
Copyright © 1999 by Harry S. Dent Jr.