As we head towards the fifth anniversary of the current bull market in March, fundamentalist investors may be feeling a little aggrieved. Certainly in the last year, if they bought stocks on the principles pioneered by Benjamin Graham and David Dodd in their 1940 classic “Security Analysis” they are likely to have underperformed the Standard and Poor’s 500 Index, which was up 30% in 2013. Warren Buffett, their most famous acolyte, himself confesses to having underperformed the index over the past 5 years. There are three possible explanations for this: (i) we are in an anomalous market, which will eventually right itself (ii) the principles are outdated or (iii) the failure of Graham and Dodd is another indication that economic policy has gone seriously off track, and disaster will follow. I will suggest that the true answer is a mixture of all three.

For those that don’t know it, “Security Analysis” is the Bible of value investing, seeking to analyze companies by reference to their intrinsic value, and invest in those that appear especially cheap, in the expectation that at some future date their stock prices will correct to a more normal level in relation to their value. Warren Buffett was a pupil of Graham’s at Columbia in 1950-51, completing a MSc in Economics. He worked for Graham for a few years then in 1956, when Graham closed his partnership, Buffett opened his, applying Graham’s investment principles, albeit with a somewhat greater focus on the growth potential of the businesses invested in.

Without detracting from Buffett’s subsequent magnificent success, one should note that, since his father had been both a stockbroker and a Republican Congressman from Nebraska, he had an excellent list of wealthy contacts who were prepared to stake his infant business. Still, his subsequent investment success, both in that investment partnership and in the subsequent Berkshire Hathaway, was undeniable, unparalleled by any other investor of his generation, and as he has said, was 85% based on Graham’s principles. Sir John Templeton, the other spectacularly successful investor of a somewhat earlier generation, who started in the 1930s and died in 2008, was also an acolyte of Graham and Dodd, profitably applying it to emerging markets investment.

However investors of subsequent generations, guided by Graham and Dodd’s excellent analysis, and later by Templeton’s and Buffett’s extraordinary success, have attempted to repeat their success and have found the effort frustrating, for one important reason: except for a fairly short period in the late 1970s and early 1980s, the principles of Graham and Dodd have been very difficult to apply in the last half-century. Even Buffett himself has faltered; the five year period 2009-13 is the first five-year period since he took over Berkshire Hathaway in 1965 in which Buffett has underperformed the S&P 500 Index, and it won’t be close, with the S&P 500 up 128% in the period, while Berkshire Hathaway’s net asset value was up only 80% in the period from January 1, 2009 to September 30, 2013. That happened even though Buffett made at least one huge inspired investment during the period, his $34 billion November 2009 purchase of Burlington Northern Santa Fe Corporation, which has given him railroad control over the U.S. fracking nexus of North Dakota’s Bakken Shale.

The explanation is simple: Graham and Dodd was written during the Great Depression, both in its initial 1934 form and its revised 1940 edition. It naturally drew on the experience of the generation up to that date, in which stock prices had been generally much lower than in the last half century, both in terms of assets and earnings. The periods of higher valuation, the brief 1919-20 postwar boom and the 1927-29 bubble, seemed exceptions to the general rule, during which values had got severely out of line. Especially in 1940, when the market had experienced nearly a decade of what appeared to be economic recovery while stock prices remained low, and consumer prices had in general deflated for more than a decade, the rules of thumb of the 1930s seemed laws of nature.

For example, one of the techniques described in great detail in Graham and Dodd was to buy shares that were trading below the value of the company’s net quick assets (cash plus accounts receivable minus debt.) That advice made a lot of sense in the 1930s; indeed Templeton applied something very like it when he made his first fortune late in that decade. However once the long 1950s boom got going, the advice became increasingly difficult to apply. Even in the deep 1970s bear market, there were very few companies trading at below their net quick assets; for one thing, leverage was already much higher in the 1970s than in the 1930s and most companies had fixed assets whose book value was far less than their true value owing to the period’s persistent inflation.

Curiously enough, adventurous investors could find companies in 2010-11 that were trading below their net quick assets. Unfortunately, those companies were Chinese small-capitalization companies that had issued shares in the United States, and their valuations had been decimated by repeated instances of accounting fraud among small Chinese companies with U.S. listings, even those which had major international auditors. The result was that almost all Chinese small-caps traded far below net asset value – but a Western investor without Chinese staff had no way of knowing whether the assets were actually there, even though there were presumably many Chinese small-cap companies that were not engaging in accounting fraud.

That brings us to the central problem of Graham and Dodd’s methods: even when they are applicable, they may not be valid when faced with the ultra-high leverage and degraded ethical standards of 2014. If companies borrow as much as possible, because their finance staff has been reared on the Modigliani-Miller Theorem, then few companies will have sufficient tangible, quickly realizable assets to cover their liabilities, let along provide a surplus that can provide solid backing for its shares. Similarly, accounting figures themselves may be inaccurate owing to cross-cultural auditing difficulties, as in China. A third possibility is that risky derivatives contracts may be lurking inadequately disclosed in the nether reaches of the Notes to the Accounts, ready to bite wary investors in a downturn (Lehman Brothers looked perfectly solvent until it wasn’t, as did Enron.) In short, not only do very few companies qualify as sound investments by Graham and Dodd standards, but those companies that appear to qualify, at least partially, are almost certainly traps of some kind.

In the current market, investors attempting to apply Graham and Dodd are drawn irresistibly to gold and silver mining companies, where a massive bear market since 2011 has driven many of their share prices far below net asset value. For example Exeter Resources (NYSE:XRA) has $43 million of net quick assets and a market capitalization of $49 million, bringing it very close to the magic level at which Graham and Dodd’s criteria are fulfilled – indeed, it crossed that level briefly in late December. Of course, Exeter has no revenues and therefore runs at a perpetual loss, but a spike in the gold price might get it bought out – you never know! (Disclosure: I own a few shares.) Still, an investment method that kicks up only a tiny obscure company in a deeply unfashionable high-risk sector is not providing investors with useful mainstream advice.

So let’s look at the three possible explanations for why Graham and Dodd doesn’t work:

The first possibility, that we are in an anomalous market that will eventually right itself, is belied by the fact that the market anomaly, whereby Graham and Dodd methods can’t find attractive investments (except purely those less grotesquely overpriced than other investments, which can by definition always be found) has persisted for 20 years. By Graham and Dodd standards, the U.S. stock market became overvalued in the late 1980s, was at the extreme high of possible valuations in February 1995, when the Dow Jones Index stood at 4,000, almost 50% higher than at the market peak seven years earlier, and soared into an unknown stratosphere with the bull market of 1995-2000, since when it has never come back. I have frequently referred to a calculation based on nominal GDP growth, which would put the market today at a level below Dow 9,000, based on its February 1995 valuation, but by Graham and Dodd standards that should be not the midpoint but the extreme upper bound of an appropriate market trading range. An anomaly that lasts for a quarter century isn’t an anomaly, it’s a new reality. If this explanation is accepted, Graham and Dodd is indeed obsolete.

Conversely, however it’s difficult to argue that Graham and Dodd’s principles are outdated. Stocks today are at high multiples of earnings, and earnings themselves are at all-time records in relation to GDP. It seems difficult to imagine long-term stability for a capitalist system in which the returns to investors absorb an ever larger share of GDP, even while the risk free real cost of capital is very low or even negative. Hence Graham and Dodd is telling us that we would be foolish to buy stocks at these levels, even if our bullish neighbors are able to sneer at us for the next decade or more. That’s not a very useful insight, because we live only a few decades, and wasting a decade or more (or three decades including the past experience) being wrong about the market is intolerable. But if we bet the other way, we should at least have our trigger finger poised to reverse course immediately when things change.

Finally, there’s the third possible explanation, that the outdatedness of Graham and Dodd, and its inapplicability to current markets, say something profound about today’s economic position. Here I think there is a core of validity. We forget that a market that goers up by substantial amounts year after year, without any great surge in economic growth propelling it, is historically unprecedented, and is causing unprecedented levels of distortion in the economic system. However an elastic band distorted more than ever before will eventually break so in the same way an economic system distorted more than ever before will eventually collapse. The possibility of a soft landing, with a gradual wind-down of today’s anomalies, is vanishingly unlikely given the huge hidden stresses built up from the massive distortions. Hence Graham and Dodd WILL eventually reassert itself, and is most unlikely to take a decade to do so. 9-18 months is more like the timeframe.

For followers of Graham and Dodd, the past quarter century has been both annoying and unprofitable. However they should not abandon their much-tried faith at this point.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)