Nifty Fifty Era

The "concept" stocks of the Go-Go years in the 1960s came, and went. So did the "Nifty Fifty" era that soon followed. The "January effect" of small-cap superiority came, and went. Option-income funds and "Government plus" funds came, and went. In the late 1990s, high-tech stocks and "new economy" funds came as well, and even today the asset values of the survivors remain far below their peaks. Intelligent investors should approach with extreme caution a claim that any new paradigm is here to stay. That's not the way financial markets work. We do know that traditional low-cost all-market-cap-weighted index funds guarantee that you will receive your fair share of stock market returns, and virtually assure that you will outperform, over the long term, 90 percent or more of the other investors in the marketplace. Maybe this new paradigm of “fundamental” indexing—unlike all the other new paradigms I’ve seen—will work. But maybe it won’t, too. I urge you investment professionals not to be tempted by the siren song of paradigms that promise the accumulation of wealth that will be far beyond the rewards of the classic index fund.general

Pension funds that fail to take into account lower future returns are courting not merely disappointment, but disaster. Pension plans—public and private alike—are now facing a $1.5 trillion deficit, assuming future returns of 7 ½% per year. In an environment of 4% gross returns on stocks, 3% gross returns on bonds, and even (generously!) 8% gross returns on alternative investments. 7 ½% looks impossible, especially when investment costs are taken into account. Even a 5% net return after costs for pension funds looks like a stretch. Here, the word “crisis” seems appropriate. Challenges to Traditional Indexing The index revolution, like all revolutions—is not without its flaws. The most recent flaw is the focus on the concept of “Smart Beta”—replacing market-cap-weighted portfolios by portfolios weighted by so-called “fundamental” factors: dividends, earnings, book values, assets, etc. As a concept, Smart Beta is not a terrible idea . . . nor is it a world-changing one. But it suffers from the assumption that past data, heavily mined, will identify factors that will provide sustainable performance leadership. Mark me as from Missouri on that one. It ignores the principle of reversion to the mean (RTM) in stock returns, market returns, and mutual fund returns. That’s a huge mistake. Once again (remember the “Go-Go” fund craze of 1965-1968 and the “Nifty Fifty” craze of 1970- 1973?)

HB: Do you think that Wall Street or the typical analyst or portfolio managers have learned their lessons of the "Go-Go" funds, the growth cult, the one-decision stocks, the two-tier market, and all? Graham: No. They used to say about the Bourbons that they forgot nothing and they learned nothing, and I'll say about the Wall Street people, typically, is that they learn nothing, and they forget everything. I have no confidence whatever in the future behavior of the Wall Street people. I think this business of greed-the excessive hopes and fears and so on-will be with us as long as there will be people. There is a famous passage in Bagehot, the English economist, in which he describes how panics come about. Typically, if people have money, it is available to be lost and they speculate with it and they lose it-that's how panics are done. I am very cynical about Wall Street. HB: But there are independent thinkers on Wall Street and throughout the country who do well, aren't there? Graham: Yes. There are two requirements for success in Wall Street. One, you have to think correctly; and secondly, you have to think independently. HB: Yes, correctly and independently. The sun is trying to come out now, literally, here in La]olla. What do you see of the sunshine on Wall Street? Graham: Well, there has been plenty of sunshine since the middle of 1974 when the bottom of the market was reached. And my guess is that Wall Street hasn't changed at all.

The 1974-75 article — rediscovered and contextualised by Jason Zweig — sets out Graham's framework for assessing whether the stock market as a whole is over- or under-valued. Graham proposes a central-value estimate based on normalised earnings, a quality-adjusted capitalisation rate, and a comparison with bond yields. The output is a single ratio: market price divided by central value. Graham argues that the ratio is a useful signal when it falls well below or above one, and that the investor should adjust his stock-bond mix accordingly. The framework's distinctive feature is that it does not forecast the market's near-term direction. Graham is explicit that the central-value estimate is too coarse to time the market in any short window. Instead, the ratio of price to central value operates as a slow-moving indicator that nudges the investor toward a larger equity allocation when the market is broadly cheap and toward a smaller one when it is broadly dear. The investor's action is incremental, not all-or-nothing. Graham's article applies the framework to the period 1965-1975, showing how the price-to-central-value ratio drifted from expensive in the late 1960s to attractive in the 1974 bear market. The implicit conclusion is that an investor who had followed the framework across the decade would have reduced equity exposure through the 1968-1972 Nifty Fifty peak and increased it through the 1973-1974 bear, ending the decade with a portfolio mix that reflected the changed pricing of equities rather than the changed mood of investors.

The 1975 article engages the inflation question directly. Graham notes that the 1970s had seen both rising consumer prices and falling equity valuations, contradicting the then-common view that equities were an automatic inflation hedge. Graham argues that the relationship between inflation and equity returns is more complicated than the simple hedge thesis: high inflation raises interest rates, which raises the capitalisation rate applied to earnings, which compresses multiples even if nominal earnings rise. Graham's framework treats inflation as a tax on purchasing power that the equity investor pays indirectly through a higher discount rate. The implication for the analyst is that the equity investor cannot simply assume that nominal earnings growth will translate into real returns; the capitalisation rate matters as much as the earnings trend. Graham's article predates the formalised discounted-cash-flow language, but the underlying argument is the same: equity returns are determined by the entry multiple as well as by the cash-flow path. The 1975 article concludes that the 1973-1974 bear market had repriced equities at a level where, on Graham's central-value framework, the equity allocation should be increased. He notes that the same framework had called equities expensive through the 1968-1972 Nifty Fifty peak, and that an investor who had rebalanced according to the rule would have entered the 1973-1975 bear with a defensive posture. Graham treats this as evidence that the central-value framework, while imprecise, did its job across the decade.